Should You Invest In Closed End Funds?
They Produce Income but the Share Price Can Be Volatile
Closed-end funds are different than open-end mutual funds.
With an open-end fund, as long as you want to buy shares, the management company will sell them to you. They will take your money, add it to the portfolio, and create more shares. You always buy shares of an open-end fund from the fund company, never on the secondary market.
When a closed-end fund starts, the company raises a set amount of money and issues a specific number of shares. No new shares are created after that point. Investors can buy the fund shares only on the secondary market, from someone else who is selling shares.
Once the initial money is raised, the fund manager manages the investments according to the fund's goals and objectives. Closed-end funds can be invested in any publicly traded securities such as equities, bonds, preferred stocks, options, etc.
Closed-End Funds May Deliver Above Average Payouts
Many closed-end funds pay monthly or quarterly dividends. They can be an attractive alternative for investors seeking income. Investors need to understand how this income is delivered. In many cases, a portion of the fund's payout is a return of principal. Some funds slowly self-liquidate over 20 to 30 years.
The share price can also be highly volatile and many closed-end funds will see their share prices go down when interest rates rise. Investors using closed-end funds should realize that although they may receive consistent income, their principal value may swing to extreme highs and lows.
Be Aware of Leverage
The share price is so volatile because many closed-end funds use leverage, or borrow against the fund, to buy more securities. The objective of this strategy is to increase the fund’s return or the amount of income it pays out.
For example, picture a regular dividend income fund that owns dividend-paying stocks. As a closed-end fund that could use leverage, this fund could borrow against the stock portfolio to buy more dividend paying stocks. Assuming interest rates were low enough their cost of borrowing would be less than the dividend yields and they could increase the payout out of the fund by using leverage this way.
This use of leverage, or borrowed funds, causes closed-end funds, like bonds, to be highly interest rate sensitive. When interest rates rise, the share price of closed-end funds may go down. This is because investors anticipate that the fund will now have to pay a higher cost on its borrowed funds, and this higher interest rate cost is expected to lower the overall return of the fund.
Shares Trade at a Premium or a Discount
When a fund trades at a discount, it means when you buy a share, you are paying less than what the market value of all of the fund's underlying investments is really worth.
When a fund trades at a premium, it means when you buy a share, you are paying more than what the market value of all of the fund's underlying investments is really worth.
Closed-end funds are best used as a complement to an overall income producing portfolio, or, for experienced investors only, by applying a disciplined trading strategy, which involves buying funds at a discount and selling them at a premium.
Do not confuse closed-end funds with closed funds. When an open-end mutual fund stops issuing shares, on a temporary or permanent basis, it will be said to be "closed." At that point, you cannot buy shares of the fund; not on the secondary market or from the fund company. These closed funds are not the same as a closed-end fund.
This Seems Difficult
Think of it this way — what you know as a mutual fund is an open-end fund. If you currently hold what your company or adviser calls mutual funds, you probably have open-end funds. Most portfolios are filled with open-end funds.
Closed-end funds function more like an exchange-traded fund. There is a smaller offering of closed-end funds and often, they're held by investors or advisers with advanced knowledge or specific goals because closed-end funds often represent higher risk.