Understand How Closed-end Funds Work

Publication
Article
Physician's Money DigestFebruary 2006
Volume 13
Issue 2

Although exchange-tradedfunds (ETFs) thesedays generally refer tothe index variety, thereis another type of ETFthat has been around for a long time. Aclosed-end fund (CEF) is an investmentcompany that comes into existencethrough an initial public offering (IPO)similar to stocks. For example, thesponsor may sell 25 million shares of anew CEF at $20 per share to the publicto raise $500 million. It then hiresone or more money managers to investthe money in stocks, bonds, or whateverelse the charter of the CEF allows. Ifthe investment managers do well, thevalue of fund holdings and its net assetvalue (NAV; the total value of its holdingsdivided by the number of sharesoutstanding) will go up, and the fund'sshareholders benefit.

Buy and Sell Shares

There are key differences betweenCEFs and open-end mutual funds, thetype of fund that most investors know.With an open-end fund, you always buyshares from or sell shares to the fundcompany itself. The transactions takeplace only once a day when the NAVhas been calculated (which typicallyoccurs after the major US exchangesclose), even though you can enter yourorder anytime during the day. You canbe sure that if the fund's investments dowell, you will make money because youcan sell at the NAV. (This is essentiallytrue for index ETFs as well.)

You can buy CEF shares only fromsomeone who already owns them or sellyour shares only to someone interestedin buying after the IPO. The fund companyis not involved in the process anymore.Therefore, the price, which maybe higher or lower than the NAV, isdetermined through a bargaining processsimilar to that for stocks. The differenceis called a premium or discount.

While an open-end fund never sellsat a premium or discount, CEFs can. Soeven if the fund's holdings do well, youmay not fully benefit because youbought your CEF shares at a premium.By the time you want to sell, shares maybe at a discount, and you will lose thedifference. Why CEFs sell at a premiumor discount is a complicated discussion,but the history is that most CEFs startselling at a discount soon after the IPO.The discount normally ranges between0% and 10% and can often grow ashigh as 20% or 30%. Premiums aregenerally rare and short-lived.

Look for Discounts

You are probably already gettingthe message that you should never buya CEF at the time of the IPO, althoughyour broker will solicit you to buy atthat time. The broker gets a large commissionsimilar to the front-end loadon a load fund. For later purchase orsales, you only pay a regular stocktransaction commission.

You should also avoid buying a CEFat any time at a premium, because sooneror later most will trade at a discount.Yet discounted CEFs can be a bargain ifyou can buy $1 of assets for $0.80 or$0.90, although the size of the discountis not the only criterion to consider. Thefund's investments and managers willultimately determine its performance.

Investors may find some good bargainsand unusual investment strategieswith CEFs, but you will need to domore research or find a knowledgeablefinancial advisor to guide you. Gettinggood information on CEFs is difficult,and it is a lot more complex to analyzea CEF than an index ETF.

Chandan Sengupta, author of The Only

Proven Road to Investment Success (John

Wiley; 2001) and Financial Modeling Using

Excel and VBA (John Wiley; 2004), currently

teaches finance at the Fordham University

Graduate School of Business and consults with individuals

on financial planning and investment management. He welcomes

questions or comments at chandansen@aol.com.

Related Videos
© 2024 MJH Life Sciences

All rights reserved.