There are many investment options for investors to choose from. While mutual funds are a huge business, many investors are unaware that there are two types of mutual funds, open end and closed end funds.
In this post, I am going to focus on talking about closed end funds, which are much smaller than their open end counterparts.
By the end of the post, you will know everything there is to know about closed end funds and will be able to decide if they make sense for your portfolio.
What Are Closed End Funds?
To understand closed end funds, we first have to look at open end mutual funds. Open end mutual funds are the ones you see talked about all the time.
They are called open end because there is no limit to the number of shares available. In other words, if you want to invest in an open end mutual fund, you simply buy into the fund and the mutual fund creates more shares so you have ownership.
With closed end funds, there are a set number of shares. So instead of buying directly from the mutual fund, you are buying funds from another investor who is selling their holding.
However, they do act like open end mutual funds in that they are managed by a team of professionals and they charge an annual management fee.
What Makes Them Unique
Now that you have a basic understanding of what closed end funds are, let’s take a minute to discuss what makes them truly unique, their pricing.
With open end mutual funds, the price is fixed throughout the day. The fund share price is calculated at the end of the trading day based on the value of the underlying securities it holds.
If you were to place a trade during the trading day for an open end mutual fund, you would get the closing price, regardless of when you place your order.
With closed end funds, the pricing structure is different. While the underlying securities do have an impact on the price per share, the share price is also impacted by supply and demand as these funds can be traded throughout the day, just like with individual stocks.
As a result of this, the share price of a closed end fund could trade at a premium or discount compared the funds value based solely on the underlying securities it holds.
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What are some factors that could lead to a closed end fund trading at a premium or discount? Here are a few reasons:
- A “hot” manager who is great at stock picking
- A “hot” sector that investors want to get in on
- Low demand from investors
- An out of favor sector
These are just a few of the reasons why a closed end fund might trade at a premium or discount.
Should You Invest In Closed End Funds?
For the majority of investors, this type of investment is not a good fit. The main reason is due to risk. There is a lot more risk with closed end funds than there is versus open end mutual funds or exchange traded funds.
This is due to the fact that the price of these securities is impacted by supply and demand. For example, you know that an open end mutual fund or exchange traded fund will always be trading at the value based on the underlying securities.
So to make a successful investment, you need to understand what assets the fund you are interested in holds.
But with a closed end fund, you need to know this and understand what is happening in the market today and tomorrow. Is a sector out of favor? Is one in high demand? Both of these will have an impact on what fund you decide to invest in.
The bottom line is that closed end funds are a better option for the bond allocation of your portfolio. This is due to the higher than average yields you can earn.
But this doesn’t mean you are guaranteed to make money. Many times high yielding closed end funds underperform the market as a whole.
At the end of the day, closed end funds should be something you look into if you are a more seasoned investor or are someone who doesn’t prefer index investing.
These types of securities can make sense in a portfolio, but they also have to fit the investors profile as well. Otherwise, the investor is doomed to fail by investing in these securities.