A closed-end stock fund is a type of mutual fund that has certain similarities to its sibling, the open-end stock fund. In both cases, a fund manager uses investors' money to buy stocks. By making one purchase in either type of mutual fund, you could own shares in hundreds or even thousands of different stocks. However, closed-end funds are priced, bought, and sold in a manner quite different from open-end funds.
A closed-end fund begins by raising funds from investors in an initial public offering, just like a stock. The fund uses this money to buy a portfolio of investments in accordance with its stated investment objective. After the initial buy-in, investor money does not flow into or out of the fund. Open-end funds are purchased directly from a mutual fund company. But after the initial offering of a closed-end fund, share are bought and sold only by individual investors. When you buy a closed-end fund, your money goes to an investor who's selling his shares, rather than to the fund company.
One of the main benefits of a closed-end fund is liquidity. Because closed-end funds trade like stocks, you can buy or sell shares any time the market is open. Also, you might be able to buy a closed-end fund at a discount to its true or "net asset" value. The per-share price of a closed-end fund is whatever price investors are willing to buy or sell at, regardless of the value of the investments within. The structure of a closed-end fund means that redemptions aren't an issue. A closed-end fund manager has a relatively stable pool of assets to use for investing, since money flows neither in nor out of the fund. This lets closed-end funds invest in more illiquid areas of the market and to remain fully invested, because the managers don't have to worry raising money rapidly to satisfy any shareholder redemptions.
Because a closed-end fund trades like a stock, you pay a commission each time you buy or sell shares. If your fund falls out of favor, its share price can drop more rapidly than the underlying net asset value. That means that even if your fund manager is turning a profit, the share price of your closed-end fund might drop. Some closed-end funds carry high expenses, lowering the performance of the fund's net asset value over time.
Closed-end funds can be volatile because many of them use leverage to enhance their returns. To use leverage, a fund manager borrows against the assets of the fund and uses that money to purchase additional investments. Although this might enhance the return of the fund, it can also make the fund go down rapidly if the market moves against it. For example, if interest rates rise dramatically, a fund can end up paying more on the money it borrows than it collects from its investments. The increased risk from a leveraged fund can increase returns in good times and decrease them in bad times.
John Csiszar has written thousands of articles on financial services based on his extensive experience in the industry. Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to his online work, he has published five educational books for young adults.