Advantages & Disadvantages of Closed-End Funds
Closed-end funds are investment companies that issue a limited number of shares that trade on an exchange like regular stocks and invest the proceeds in stocks, bonds or other financial assets. Closed-end funds’ unique features and structure can work as either advantages or disadvantages for investors, depending on the situation.
Discount vs. Premium
A closed-end fund’s shares have two sets of values: current price and net asset value, or NAV. Current price is what the shares are currently trading for on an exchange; NAV is what the fund’s assets are worth at current market prices. The NAV per share is calculated daily by dividing a fund’s total assets by the number of shares outstanding; the current price is set by the market. As a result, the current price can be more or less than the NAV. If the current price is less than the NAV, the shares are said to be trading at a discount; if the current price is more than the NAV, the shares are said to be trading at a premium. Buying closed-end fund shares at a 10 percent discount is essentially paying 90 cents for a dollar’s worth of stocks or bonds and is obviously to your advantage. Buying closed-end fund shares at a premium does not make much sense because you are overpaying for the market value of stocks or bonds.
Closed-end funds often borrow money to increase their assets and boost returns. Leverage can be both an advantage and a disadvantage because it magnifies both gains and losses.
Funds are supposed to be held long term. Being able to buy and sell closed-end fund shares throughout the day can help you take advantage of short-term trading opportunities or avoid an imminent disaster by selling at the first sign of trouble, but it can often lead to overtrading and poor returns. Closed-end fund shares are susceptible to sudden intraday drops that can shake you out of your investment unnecessarily, because more often than not the stock price returns to the old level by the end of day or within the next several days.
Access to Specific Asset Classes
One definite advantage that closed-end funds offer is access to specialized assets such as junk bonds or bank loans. Many mutual funds invest in junk bonds, but when you add a discount and leverage, you can get a much higher yield on the same bonds held by a regular fund. It’s hard for mutual funds to hold bank loans, because bank loans are not marketable securities and are not liquid -- they cannot be traded in small increments -- whereas a mutual fund must be able to buy and sell assets daily as investors buy and redeem its shares. Since trading in closed-end fund shares does not affect its holdings, a closed-end fund can hold multimillion dollar bank loans long term for the benefit of the investors.
Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.