Closed-end funds, also referred to as CEF’s, can be an effective investment tool for those looking to invest in a non-conventional form of a mutual fund. Just like open-end mutual funds, those most investors are familiar with, closed-end funds have many options to invest in ranging from stock, commodities, fixed income and some are even narrow enough to focus on a specific industry or region. The main difference between open-end funds and CEFs is that CEF’s have a fixed number of shares, or units, outstanding that are issued through an initial IPO and do not issue new shares in the fund. There are some nuances to close-ended funds that are important to understand when considering how to invest in one.
Since new money is not being contributed into a closed-end fund like a traditional mutual fund, the cash assets generally remain fully invested at all times.
In comparison, an open-end fund must manage continuous cash flows. When an open-end fund offers new shares to investors and receives additional funds, these funds remain in a cash position or money market fund until re-invested.
This is also why a closed-end fund trades throughout the day, comparable to a stock, and open-end funds are priced end-of-day. Understanding this is important when considering how to invest in a closed-ended fund as the price will vary.
When shares of a CEF are bought and sold, this is done directly between investors, unlike a traditional fund which will offer new shares at a premium with a higher fee typically built into the fund. Over time, this reduced expense can lead to a higher return for the investor.
A CEF will generally distribute income and dividends on a monthly or quarterly basis, compared to traditional funds that typically offer annual or semiannual distributions. This is important to be aware of when investing in a CEF as the timing of payments can impact the cost of the shares. This is also a preferred payment schedule for investors as it allows earnings to be received and reinvested more quickly.
When considering how to invest in a close-ended fund it is important to keep in mind that close-ended funds are more volatile than a traditional fund. Investors can buy and sell shares throughout the day so the price can move significantly. A traditional fund is priced at the end of each day, which smooths out the daily fluctuations seen in a close-ended fund.
Many closed-end funds take advantage of borrowing money in an attempt to heighten returns. This adds several risks to many close-ended funds as first they need to pay interest on any debt, reducing returns, and second, they face the risk of not being able to make payments on the funds’ debt.
Once an investor has decided a closed-end fund is the route they want to take, the next step will be choosing a fund. Just like traditional funds, an investor may choose from a global or international fund, sector-specific or specialty fund, fixed income, or equity funds. The choices are varied and will come down to the specific goals and portfolio of the investor.