The ins and out of closed-end funds — and when to buy them

Closed-end funds are a lot like conventional, open-end mutual funds. They hold a diversified portfolio of stocks, chosen by a fund manager who gets a fee for his or her services (a key portion of the overall Management Expense Ratio, or MER).

The key difference between an open-end and closed-end fund is that an open-end fund stands ready to sell new fund units, or redeem existing fund units, on demand. A closed-end fund, on the other hand, works with a fixed asset base invested in a portfolio of securities. The value of those assets rises and falls, depending on how the closed-end fund invests. Its units trade like a stock’s shares, and mostly on a stock exchange.

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The fund’s units may trade above the per-unit value of the investments it owns—“at a premium” to net asset value, as brokers say. Mostly, however, they trade at a discount.

This discount is partly due to broker inattention. Brokers have no incentive to sell closed-ends funds to their clients after they go public. They can make larger commissions plus a string of yearly trailer fees by selling open-end funds instead of closed-end funds. For that matter, brokers have a regular stream of new “products” to sell that usually pay high commissions because they are new to the market.

Closed-End Funds are Infrequently Traded

Closed-end funds also tend to be infrequently, or thinly, traded. That’s partly because they give you exposure to a portfolio of stocks rather than just one company, so they don’t go through the kinds of changes that would spur trading.

If the discount to net asset value for a closed-end fund persists, unitholders of the fund may try to persuade the managers of the fund to try and close the discount. The most obvious way would be for the managers to convert the fund into a traditional open-ended mutual fund.

When that happens, much of the discount disappears overnight, and the fund’s shares may jump 10% to 30% or more. Holders can then redeem their shares for net asset value, though they may have to pay a fee.

Buying Back Units

However, the major shareholders of a closed-end fund may hold over 50% of the units outstanding, so they will likely continue to maintain the closed-end status of the fund.

Meanwhile, another way for a manager to close the discount on net asset value is to buy back some of the fund’s units. By purchasing units at less than net asset value, it raises the net asset value for the remaining shareholders, and this works to close the discount.

Over a period of years, units in well-managed closed-end funds will occasionally come close to net asset value. That’s just one more way for investors to get a chance to extract most of the value of the fund’s portfolio. However, you may need to wait many years for the opportunity, so closed-end funds are buys only for patient investors.

We only recommend buying closed-end funds when they hold assets that are attractive to buy or hold on their own, and when the fund’s units trade at a discount to the per-unit value of the fund’s assets. If you buy under those circumstances, you’ll have more assets working for you than you paid for.

We only recommend buying closed-end funds when they hold assets that are attractive to buy or hold on their own, and when the fund’s units trade at a discount to the per-unit value of the fund’s assets. If you buy under those circumstances, you’ll have more assets working for you than you paid for

Do you invest in closed-end funds? Why or why not?