What Is a CEF?: A Closer Look at Closed-End Funds

Differences between CEFs and Mutual Funds

woman looking at stock prices
Are CEFs a wise investment choice for you?. Bill O'Connell / Getty Images

There are two different types of mutual funds: open-end funds and closed-end funds. The former is the type that most investors think about in association with investing in mutual funds and the latter is typically overlooked or misunderstood.

Despite the similarities of closed-end funds (CEFs) and mutual funds, they have distinct differences and each has its own purpose and structure.

Buying and Selling CEFs

A CEF trades like a stock -- on a stock exchange or over-the-counter -- while an open-end mutual fund is bought and sold directly with the fund company or a brokerage firm.

In this regard, CEFs are similar to exchange-traded funds (ETFs). The cost of the transaction for a CEF is similar to the cost of a stock trade. There are also internal management fees paid to the fund company to manage the fund.

Another cost to be aware of for a CEF is the bid-ask spread. If you place an order to buy a CEF and, at the same time, place an order to sell the fund, the prices for both would be different. In other words, your cost to buy the CEF and the price you would get for selling the CEF would be different. For instance, you might sell at the bid price of $9.90, while you would buy at the ask price of $10. This $.10 difference is known as the bid-ask spread and is considered the cost of doing business on the exchange or over the counter.

You can buy both CEFs and mutual funds through a broker. The broker processes the transaction on the stock exchange in the case of CEF, or with the fund company in the case of mutual funds.

Net Asset Value vs. Price of CEFs

It is easy to confuse the net asset value (NAV) of the CEF with the fund’s price. To avoid confusion, you can simply think of the NAV as the value of the CEF’s holdings (stocks, bonds, cash, etc.) minus any liabilities, divided by the total number of fund shares that are held by investors.

Therefore, unlike a mutual fund, the NAV of a CEF is not the price you pay for a share of the fund.

CEF s are often bought or sold at a discount to their NAV. In other words, if a CEF owns 100 stocks that have a combined value of $1,000,000 with $0 liabilities and 100,000 shares outstanding, the fund has an NAV of $10. Investors might not value the portfolio manager’s ability to pick stocks, however, so they might only be willing to pay $9 per share of the fund. So, this fund would be trading at a discount of 10% to its NAV.

Why Do Fund Companies Choose the CEF Structure?

There are many reasons a fund company might decide to structure their fund as a CEF rather than an open-end mutual fund (and vice-versa). It could be that the fund company has a particular niche that is better served through CEFs. For example, if a fund company wants to manage a fund that holds securities that are not easy to trade (illiquid, such as stock of a very small company that is rarely traded on the stock exchange), then they might form a CEF. This is because the fund managers are not forced to sell a particular security when an investor wants to sell his/her shares of the fund. Again, like an ETF, CEFs don't hold underlying securities like open-end mutual funds.

Are CEFs a Wise Investment Choice For You?

The bottom line here is that CEFs are niche investments that have an added layer of strategy and complexity compared to the everyday open-end mutual funds that most of us understand.

As always, it's important to understand investments before you buy shares. If you're not confident in your decision, it's probably not a good idea to invest.

Updated by Kent Thune, November 27, 2016