Closed-End Funds: Definition, Pros & Cons

What Is a Closed-End Fund?

Closed-End Fund Definition

A closed-end fund (CEF) is a type of Exchange Traded Fund (ETF) or Mutual Fund whose shares are listed on a stock exchange. The fund will hold a portfolio of investments, and investors can buy into (or sell out of) that investment pool by trading the CEF during regular stock market hours. A closed-end fund has a fixed number of shares outstanding, meaning that investors will buy and sell the shares from each other at a price determined by supply and demand.

Shares Outstanding

For ETFs that are open ended (aren’t closed-ended), the fund administrator will increase or reduce the number of outstanding shares based on buying and selling volumes. The fund administrator will conduct these transactions at the NAV (Net Asset Value) per share.

For closed-end funds, there exists a fixed number of shares, and the fund administrator will not increase or decrease the share count. CEFs trade more like individual stocks based on buyer demand and selling pressure.

Note: Closed-end fund managers could choose to pursue a new share issuance on the secondary markets to increase the number of shares outstanding, similar to a company that raises additional capital from investors.

Buying & Selling Closed-End Funds

Investors who want to invest in CEFs will need a brokerage account to buy and sell shares.

Market Price of Closed-End Funds

Since fund administrators of open-end funds issue and redeem shares in their ETFs at the Net Asset Value of the fund, the ETF’s market price will not stray, at least not materially, from its NAV value.

On the other hand, closed-end funds do not issue or redeem shares in this manner. As a result, the market price of CEFs can stray significantly from the net asset value, all dependent on buying demand and selling pressure. Shares of CEFs will reach an equilibrium price, just like the stocks of individual companies, based on demand and supply for shares.

If demand outstrips supply, the price of the CEF might exceed the Net Asset Value (~trade at a “premium”) of the shares. If there is more selling pressure than buyers can accommodate, the price of the CEF might trade below it’s Net Asset Value (~trade at a “discount”).

Pros & Cons of Closed-End Mutual Funds

Pros:

• Shares of closed-end funds can be purchased and sold anytime during stock market hours.
• In some cases, investors can potentially buy a CEF for a price less than its net asset value per share.
• The fund managers of a CEF don’t need to maintain a cash reserve to redeem/repurchase shares from investors. This can reduce performance drag that may otherwise be attributable to holding cash.
• CEFs may be able to offer higher returns due to the heavier use of leverage.

Cons:

• For sellers, the market price of a CEF, at a given time, may be lower than the true fair value (the NAV) of the shares.
• For buyers, the market price of a CEF, at a given time, may be higher than the true fair value (the NAV) of the shares.
• Market liquidity in a CEF may be limited, presenting further price risk in the case an investor wishes to buy or sell a large number of shares.
• CEFs often have higher management fees that other ETFs

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 usually actively managed, thereby incurring higher trading costs and manager fees. Most open-ended ETFs are designed to track performances of indexes, and thus incur lower fees.

Second, the price of an CEF often diverges from its net asset value, and the difference can be substantial at times. On the other hand, the price of an ETF normally trades 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.”

Bottom Line

• The number of shares of a CEF is fixed, in contrast to open-ended ETFs.
• CEF shares are sold on the primary market through a public offering, much like an IPO. Secondary offerings are possible.
• Shares of ETFs, including closed-end funds, can be purchased and sold anytime during stock market hours.
• The price of a CEF can be substantially different from its net asset value.

FAQs

• What’s one risk specifically attributed to a closed-end fund?

  A risk specific to a closed-end fund is that its price can be substantially different from its net asset value. Many CEFs also use leverage, which makes them more volatile than open-end funds.

• Do closed-end funds provide income?

  An investor holding a CEF will have the potential to collect period income such as dividend or interest payments.

• Which company is the largest provider of CEFs?

  One of the largest providers of CEFs is Nuveen, an asset management company that is owned by the financial planning firm TIAA.