THE ABCs OF CLOSED END MUTUAL FUNDS
Most investors are familiar with open end mutual funds because these are the common type of mutual funds that have been offered for decades by major investment companies. Few investors are familiar with a less common type of mutual fund: a closed end mutual fund. Closed end funds are worth considering as a potential source of enhanced return.
Closed end funds are similar to open end funds in the sense that both fund types can be used as vehicles through which to invest in a variety of asset types including domestic stocks, foreign stocks, taxable bonds, municipals, and even alternatives. While open end mutual funds are more familiar, closed end funds can offer investors better rates of return when the funds can be bought at an attractive discount.
Let’s start from the beginning and learn what makes closed end funds special relative to open end funds.
The first step is to understand the term net asset value (per share) or NAV. A fund’s NAV is the total value of the fund’s assets (less liabilities) divided by the number of shares that investors hold in the fund. For example, if a fund has a portfolio worth $100 million and has issued 5 million shares to investors, the fund’s NAV will be $20.00 per share. If tomorrow the financial markets move such that the fund’s portfolio rises to $101 million or falls to $99 million than the funds NAV will rise to $20.20 or fall to $19.80 per share.
Investors in open end funds transact directly with the mutual fund (or through a broker) to obtain more shares or to redeem their existing shares. The investment company managing the fund allows the size of the fund to expand in size to meet investor demand for new shares and contract in size in order to meet investor requests to sell or redeem their shares. That is why the funds are known as “open end” – because the number of shares outstanding has not been closed or fixed.
Investors in no-load open end funds can buy or sell at the end of a trading day at the fund’s NAV which is based on the closing value of the fund’s underlying portfolio at the end of the same trading day. This means that investors can buy into the fund on the day of their choice, receive the performance of the fund’s portfolio (less the fund’s expenses) while they hold the shares, and then exit the fund on the day of their choice.
While the ability of fund investors to enter and exit the open end fund on a daily basis offers attractive liquidity to the investors, it can create expenses to the fund, especially when the fund’s portfolio is invested in assets that are relatively expensive to trade. Simply put, open end funds incur expenses from the ebb and flow of its size and these expenses are ultimately passed on the fund’s investors.
Closed end funds generally have a fixed number of shares. They are initially issued through brokerage firms. For example, 10 million shares of a closed end fund might initially be issued at a net price of $19 per share which raises $190 million to be invested in the fund’s portfolio. The closed end fund then begins trading on a public exchange such as the New York Stock Exchange so that it can be bought and sold by investors just like an ordinary stock.
Investors in closed end funds cannot generally buy new shares from the mutual fund’s investment company nor can they generally sell their shares back to the investment company. Investors must buy and sell shares in the market. The key feature of closed end funds is that investors can often buy or sell the shares at market prices that will generally differ from the fund’s NAV. When a trade takes place at a price higher than the fund’s NAV it is said to have traded at a premium. More commonly the trades take place at a price lower than the fund’s NAV and is said to have traded at a discount.
Wise investors can time their trades to buy closed end funds at discounts that may generate better performance than is offered by otherwise similar open end funds. Which type of mutual fund, open end or closed end, is better for an investor? It depends on the sophistication of the investor or the investor’s advisor. How can a sophisticated investor identify closed end fund discounts that can increase a portfolio’s performance? I address that key question in my next article “How to Select a Closed End Mutual Fund”.