A closed-end fund is a type of mutual fund whose shares can be purchased and sold on a stock exchange like a stock. It has a fixed number of shares outstanding and no new shares will be issued by the fund after its initial public offering.
What Is a Closed-End Fund?
A closed-end fund (CEF) is a type of mutual fund whose shares can be purchased and sold on a stock exchange. It is called closed-end because it has a fixed number of shares outstanding and no new shares will be issued by the fund after its initial public offering.
Closed-End Fund Definition
The fixed number of shares issued by a closed-end fund can not be redeemed by investors. Instead, shares are traded on a public exchange. When a fund “closes”, which means that all the new shares are sold, no new shares will be created and no new money will be added into the fund. Its price is based on supply and demand of the fund, and not by its net asset value (NAV), unlike an open-ended fund.
Investors looking for fixed-income are attracted to closed-end bond funds because many provide a periodic stream of income.
An investor holding a CEF will be required to collect realized capital gains distributions as they are passed through to shareholders, along with periodic income such as dividend or interest payments. Moreover, investors realize price appreciation from the share price of a CEF only if they sell shares.
Pros & Cons of Closed-End Mutual Funds
Pros:
- Shares of closed-end funds can be purchased and sold anytime during stock market hours. Its price is known in advance.
- May be able to offer higher returns due to the heavy use of leverage, especially for bond funds.
- Closed-end funds can be purchased at a discount to its net asset value.
- No need to maintain a large cash reserve because its shares are not redeemable like open-ended funds, and thus it has more available cash to invest.
- It can own unlisted securities thus a broader opportunity set with higher income and return potential.
Cons:
- Its liquidity depends on the supply and demand of shares in the open market, and can therefore be less liquid.
- Subject to additional volatility since its net asset value is different from its price.
- Losses are amplified due to greater use of leverage.
Pros & Cons of Closed Funds vs. Open
Advantages of Closed Funds vs. Open Funds
- Shares of closed-end funds can be purchased and sold anytime during stock market hours. Open-end funds can only be traded at the end of the trading day, and its price is based on the net asset value of the fund at that time.
- No need to maintain a large cash reserve because its shares are not redeemable like open-end funds, and thus has more available cash to invest. Open-end funds generally need to maintain a higher level of cash reserve to meet redemption requests by its investors.
Disadvantages of Closed-End
- Subject to additional volatility since it is traded by market participants.
- Less liquid than open-end funds because a seller of closed-end fund must find a willing buyer.
Closed-End Fund & NAV
The price of a share of closed-end fund can be different from its net asset value. While a fund’s net asset value is calculated regularly, it is different from its share price, which is determined by the market forces of supply and demand.
A closed-end fund can be traded at a premium (where its price is above its net asset value) or can be traded at a discount. Reasons for this discrepancy can include name recognition of manager and firm, investor perception of fund’s current and future performance and general investor sentiment.
CEF vs. ETFs
Both CEFs and exchange-traded funds (ETFs) are traded on exchanges, but there are clear differences between the two. First, CEFs are actively managed, thereby incurring higher trading costs. Most ETFs are designed to track performances of indexes, and thus incur lower trading fees.
Second, the price of an CEF often diverges from its net asset value, and the difference can be substantial at times, whereas the price of an ETF is within a narrow range of its net asset value.
A CEF can only be purchased and sold on an exchange, whereas an ETF can be purchased and sold either through the open market, or be exchanged for the fund’s underlying assets with enough shares to form something called a "creation unit." Because this second method allows for arbitrage if the price of the fund diverges too much from its net asset value, an ETF’s price is never too far from its NAV.
Buying & Selling Closed-End Funds
Investors who want to invest in CEFs will need a brokerage account to buy and sell shares.
Bottom Line
- Shares of closed-end funds can be purchased and sold anytime during stock market hours.
- The number of shares of a CEF is finite and fixed, and sold on the primary market through a one-time public offering.
- The price of a CEF can be substantially different from its net asset value.
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