Fixed-income investors are often attracted to closed-end funds because many of

the funds are designed to provide a steady stream of income, usually on a monthl
y or quarterly basis as opposed to the biannual payments provided by individual
bonds.
Perhaps the easiest way to understand the mechanics of closed-end mutual funds i
s via a comparison to open-end mutual and exchange-traded funds with which most
investors are familiar. All these types of funds pool the investments of numerou
s investors into a single basket of securities or fund portfolio. While at first
glance it may seem like these funds are quite similar - as they share similar
names and a few characteristics - from an operational perspective, they are actu
ally quite different. Here we'll take a look at how closed-end funds work, and w
hether they could work for you.(For a general overview of mutual funds, see our
Mutual Fund Basics Tutorial.)
Open-End vs. Closed-End
Open-end fund shares are bought and sold directly from the mutual fund company.
There is no limit to the number of available shares because the fund company can
continue to create new shares, as needed, to meet investor demand. On the rever
se side, a portfolio may be affected if a significant number of shares is redeem
ed quickly and the manager needs to make trades (sell) to meet the demands for c
ash created by the redemptions. Costs associated with this trading activity are
shared by all investors in the fund, so the investors who remain in the fund sha
re the financial burden created by the trading activity of investors who are red
eeming their shares.
On the other hand, closed-end funds operate more like exchange-traded funds. The
y are launched through an initial public offering (IPO) that raises a fixed amou
nt of money by issuing a fixed number of shares. The fund manager takes charge o
f the IPO proceeds and invests the shares according to the fund's mandate. The
closed-end fund is then configured into a stock that is listed on an exchange an
d traded in the secondary market. Like all shares, those of a closed-end fund ar
e bought and sold on the open market, so investor activity has no impact on unde
rlying assets in the fund's portfolio. This trading distinction can be an advant
age for money managers specializing in small-cap stocks, emerging markets, high-
yield bonds and other less liquid securities. On the cost side of the equation,
each investor pays a commission to cover the cost of personal trading activity (
that is, the buying and selling of a closed-end fund's shares in the open market
). (To learn more, see Introduction To Exchange-Traded Funds.)
Like open-end and exchange-traded funds, closed-end funds are available in a wid
e variety of offerings. Stock funds, bond funds and balanced funds provide a ful
l range of asset allocation options, and both foreign and domestic markets are r
epresented. Regardless of the specific fund chosen, closed-end funds (unlike som
e open-end and ETF counterparts) are all actively managed. Investors choose to p
lace their assets in closed-end funds in the hope that the fund managers will us
e their management skills to add alpha and deliver returns in excess of those wh
ich would be available via investing in an index product that tracked the portfo
lio's benchmark index. (To learn more, read Words From The Wise On Active Manage
ment.)
Pricing and Trading: Take Note of the NAV
Pricing is one of the most notable differentiators between open-end and closed-e
nd funds. Open-ended funds are priced once per day at the close of business. Eve
ry investor making a transaction in an open-end fund on that particular day pays
the same price, called the net asset value (NAV). Closed-end funds, like ETFs,
have an NAV as well, but the trading price, which is quoted throughout the day o
n a stock exchange, may be higher or lower than that value. The actual trading p
rice is set by supply and demand in the marketplace. ETFs generally trade at or
close to their NAVs.
If the trading price is higher than the NAV, closed-end funds and ETFs are said
to be trading at a premium. When this occurs, investors are placed in the rather
precarious position of paying to purchase an investment that is worth less than
the price that must be paid to acquire it.
If the trading price is lower than the NAV, the fund is said to be trading at a
discount. This presents an opportunity for investors to purchase the closed-end
fund or ETF at a price that is lower than the value of the underlying assets. W
hen closed-end funds trade at a significant discount, the fund manager may make
an effort to close the gap between the NAV and the trading price by offering to
repurchase shares or by taking other action, such as issuing reports about the f
und's strategy to bolster investor confidence and generate interest in the fund.
Closed-End Funds' Use of Leverage
Closed-end funds have another quirk unique to their fund structure. They often m
ake use of borrowings, which, while adding an element of risk when compared to o
pen-end funds and ETFs, can potentially lead to greater rewards. This leverage i
s the main reason why closed-end funds typically generate more income than open-
end and exchange-traded funds.
Why Closed-End Funds Aren't More Popular
According to the Closed-End Fund Association, closed-end funds have been availab
le since 1893, more than 30 years prior to the formation of the first open-end f
und in the United States. Despite their long history, however, closed-end funds
are far outnumbered by open-ended funds in the market.
The relative lack of popularity of closed-end funds can be explained by the fact
that they are a somewhat complex investment vehicle that tends to be less liqu
id and more volatile than open-ended funds. Also, few closed-end funds are follo
wed by Wall Street firms or owned by institutions. After a flurry of investment
banking activity surrounding an initial public offering for a closed-end fund, r
esearch coverage normally wanes and the shares languish.
For these reasons, closed-end funds have historically been, and will likely rema
in, a tool used primarily by relatively sophisticated investors.
Conclusion
Investors put their money into closed-end funds for many of the same reasons tha
t they put their money into open-end funds. Most are seeking solid returns on th
eir investments through the traditional means of capital gains, price appreciati
on and income potential. The wide variety of closed-end funds on offer and the f
act that they are all actively managed (unlike open-ended funds) make closed-end
funds an investment worth considering. From a cost perspective, the expense ra
tio for closed-end funds may be lower than the expense ratio for comparable open
-ended funds.