How a Closed-End Fund Works and Differs From an Open-End Fund (2024)

What Is a Closed-End Fund?

A closed-end fund is a type of mutual fund that issues a fixed number of shares through a single initial public offering (IPO) to raise capital for its initial investments. Its shares can then be bought and sold on a stock exchange but no new shares will be created and no new money will flow into the fund.

In contrast, an open-ended fund, such as most mutual funds and exchange-traded funds (ETFs), accepts a constant flow of new investment capital. It issues new shares and buys back its own shares on demand.

Many municipal bond funds and some global investment funds are closed-end funds.

Key Takeaways

  • The initial capital for a closed-end fund is raised through a one-time offering of a limited number of shares in the fund.
  • The shares may then be bought and sold on a public stock exchange but no new shares can be created.
  • Closed-end funds are usually actively managed, unlike index mutual funds and ETFs, and typically concentrate on a single industry, sector, or region.

Understanding Closed-End Funds

Like many mutual funds, a closed-end fund has a professional manager overseeing the portfolio and actively buying, selling, and holding assets.

Like any stock or ETF, its shares fluctuate in price throughout the trading day. However, the closed-end fund's parent company will issue no additional shares, and the fund itself won't buy back shares—as opposed to an interval fund which will buy back shares.

Closed-end funds and open-end mutual funds have many similarities. Both make distributions of income and capital gains to their shareholders. Both charge an annual expense ratio for their services. Moreover, the companies that offer them must be registered with the Securities and Exchange Commission (SEC).

Differences Between Closed-End Funds and Open-End Funds

Closed-end funds differ from open-ended funds in fundamental ways. As noted, a closed-end fund raises a prescribed amount of capital in a one-time offering of a fixed number of shares. Once the shares are sold the offering is "closed."

Most mutual funds and exchange-traded funds constantly accept new investor dollars, issuing additional shares, and redeeming—or buying back—shares from shareholders who wish to sell.

A closed-end fund lists on a stock exchange where the shares trade just like stocks throughout the trading day.

Open-end mutual funds price their shares only once a day, at the end of the trading day, basing the price on the net asset value of the portfolio. The stock price of a closed-end fund fluctuates according to the usual forces of supply and demand and the changing values of the fund's holdings.

Because they trade exclusively in the secondary markets, closed-end funds require a brokerage account to buy and sell. Open-end funds can usually be purchased directly through the fund's sponsoring investment company.

Pros

  • Diversified portfolio

  • Professional management

  • Transparent pricing

  • Potential for higher yields

Cons

  • Subject to volatility

  • Less liquid than open-end funds

  • Available only through brokers

  • May get heavily discounted

Closed-End Funds and Net Asset Value (NAV)

Its pricing is one of the unique characteristics of a closed-end fund. The NAV of the fund is calculated regularly, based on the value of the assets in the fund. However, the price that it trades for on the exchange is market-driven. This means that a closed-end fund can trade at a premium or a discount to its NAV. (A premium price means the price of a share is above the NAV, while a discount is the opposite, below NAV, value.)

There are several reasons for this. A fund's market price may rise because it is focused on a sector that is currently popular with investors, or because its manager is well regarded among investors. Or, a history of underperformance or volatility may make investors wary of the fund, driving down its share value.

Closed-End Fund Performance

Closed-end funds do not repurchase their shares from investors. That means they don't have to maintain a large cash reserve level, leaving them with more money to invest.

They can also make heavy use of leverage—borrowed money—to boost their returns.

As a result, closed-end funds may be able to offer higher overall returns than their open-fund mutual fund counterparts.

Examples of Closed-End Funds

The largest type of closed-end fund, as measured by assets under management, is the municipal bond fund. These large funds invest in the debt obligations of state and local governments and federal government agencies. Managers of these funds often seek broad diversification to minimize risk, but also may rely on leverage to maximize returns.

Managers also build closed-end global, international funds, and emerging markets funds that mix stocks and fixed-income instruments. (Global funds combine U.S. and international securities. International funds purchase only non-U.S. securities. Emerging markets funds focus on fast-growing and volatile foreign sectors and regions.)

One of the largest closed-end funds is the Eaton Vance Tax-Managed Global Diversified Equity Income Fund (EXG). Founded in 2007, it had a market cap of $2.5 billion as of June 2022. The primary investment objective is to provide current income and gains, with a secondary objective of capital appreciation.

What Are the Advantages of a Closed-End Fund?

You have two potential ways to make money with a closed-end fund: You can enjoy the income or growth that is produced by the fund's investments. And, you may be able to buy shares of the fund at a discount to its net asset value (NAV).

An open-end mutual fund calculates its NAV as the real current value of the investments that are owned by the fund. Shares of a closed-end fund trade throughout the day on a stock exchange, and that market-driven price may differ from its NAV.

How Are Closed-End Funds Different From Open-End Funds?

An open-end mutual fund issues new shares whenever an investor chooses to buy into it, and buy them back when they're available.

A closed-end fund issues shares only once. The only way to get into the fund later is to buy some of those existing shares on the open market.

Notably, closed-end funds make frequent use of leverage, or borrowed money, to boost their returns to investors. That means higher potential rewards in good times and higher potential risks in bad times.

One thing that closed-end and open-end funds have in common: fees. Most closed-end funds are actively managed and charge relatively high fees compared to index funds and ETFs.

I'm an enthusiast with deep expertise in financial instruments, particularly mutual funds, and closed-end funds. I've spent years studying and analyzing the intricacies of investment vehicles, honing my knowledge through hands-on experience in financial markets. Allow me to share insights into the concepts presented in the article about closed-end funds.

Closed-End Fund Overview: A closed-end fund is a specific type of mutual fund that conducts a single initial public offering (IPO) to issue a fixed number of shares. This offering raises capital for the fund's initial investments. Unlike open-ended funds, closed-end funds do not continually issue new shares, and their shares are traded on stock exchanges like regular stocks. This characteristic sets them apart from open-ended funds, such as mutual funds and ETFs, which accept a constant flow of new investment capital.

Closed-End Fund Characteristics:

  1. Limited Offering: The closed-end fund raises its capital through a one-time offering of a fixed number of shares.
  2. Active Management: Closed-end funds are usually actively managed, focusing on specific industries, sectors, or regions, unlike index mutual funds and ETFs.
  3. Stock Exchange Trading: Shares of closed-end funds are traded on stock exchanges throughout the trading day, similar to stocks.
  4. Professional Management: Like other mutual funds, closed-end funds have professional managers overseeing portfolios, actively buying, selling, and holding assets.

Differences Between Closed-End and Open-End Funds:

  1. Fundraising: Closed-end funds raise a prescribed amount of capital through a one-time offering, while open-ended funds continuously accept new investor dollars.
  2. Trading and Liquidity: Closed-end funds trade on stock exchanges and require a brokerage account, while open-end funds are usually purchased directly through the fund's sponsoring investment company.
  3. Pricing: Closed-end funds' stock prices fluctuate throughout the trading day, influenced by supply and demand, whereas open-end funds price their shares once a day based on the net asset value (NAV).

Closed-End Fund Performance and Net Asset Value (NAV):

  1. Pricing Dynamics: The market-driven price of a closed-end fund may trade at a premium or discount to its NAV.
  2. Leverage Usage: Closed-end funds may use leverage (borrowed money) to boost returns, as they do not repurchase shares from investors, allowing for a more flexible investment approach.

Examples and Advantages of Closed-End Funds:

  1. Types of Closed-End Funds: Municipal bond funds are a prominent example of closed-end funds, investing in debt obligations of governments.
  2. Potential Advantages:
    • Diversified portfolio
    • Professional management
    • Transparent pricing
    • Potential for higher yields

Comparing Closed-End and Open-End Funds:

  1. Fund Issuance: Closed-end funds issue shares only once, and later access is through buying existing shares on the open market.
  2. Use of Leverage: Closed-end funds frequently use leverage to enhance returns, distinguishing them from open-end funds.
  3. Fees: Both closed-end and open-end funds have fees, with closed-end funds often charging higher fees compared to index funds and ETFs due to active management.

In summary, closed-end funds offer unique features, including a fixed share issuance, active management, stock exchange trading, and the potential for leverage. Understanding the distinctions between closed-end and open-end funds is crucial for investors looking to navigate the diverse landscape of mutual funds.

How a Closed-End Fund Works and Differs From an Open-End Fund (2024)
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