Today, almost all investors know about mutual funds, the first choice for college and retirement savers who want to leave stock and bond picking to the pros. But even experienced investors may be unfamiliar with the small subset, closed-end funds, which are traded like stocks rather than bought from the fund company like the better-known open-ended funds.
Closed-end funds (CEFs) totaled $275 billion in assets at the end of 2017, compared to $18.7 trillion for the mutual fund industry as a whole, according to the Investment Company Institute. About 60 percent of CEF assets are in bond funds, the ICI says, highlighting their appeal to income-oriented investors.
While CEFs have many fans, some experts warn that this might not be the best time for a beginner to jump in with both feet. If stocks or bonds were to tumble, you could get stuck with your shares, because a CEF sale requires a buyer, and they might be scarce in a market freefall.
[See: 7 Ways to Invest in Closed-End-Funds.]
“Unlike open-end funds, the market for closed-end funds can be illiquid, meaning that you are not always able to buy or sell closed-end funds at will,” says Gary Rudow, managing director for investments at Stifel, a brokerage and investment banking firm headquartered in St. Louis.
Closed-end funds are actually the original model for mutual funds. Unlike open-ended funds, which create shares when investors put money in, and retire them when investors pull out, CEFs have a fixed number of shares created at the start. Like open-ended funds, each CEF share has a net asset value (NAV) figured by dividing the total value of stocks and bonds in the fund by the number of shares.
But high demand can drive CEF share prices above the NAV, while low demand could leave shares trading for less. The premium or discount depends on investors’ view of the fund management, how the strategy will fare under expected market conditions, and theories about how demand will ebb and flow.
Among the pros: With a fixed number of shares, a CEF may well have lower fees than a comparable open-ended fund, though some experts say they are not often as cheap as indexed products like exchange-traded funds. Fans say CEF managers can focus better on managing the portfolio without having to worry about freeing up cash for redemptions.
Because CEFs are traded like stocks, you can buy or sell at the market price anytime during the trading day. With an open-ended fund you buy or sell at the NAV calculated after the market closes. CEFs are therefore more nimble — if there are buyers and sellers you can get in quickly if the market spikes and out if it drops.
But the CEF owner who wants out may not find a buyer, and will have to ride the share price down, while the open-end fund investor is guaranteed the right to redeem at the end-of-day price.
Stock market trading also means you are charged a broker’s commission for every CEF trade, while there is no transaction fee for buying and redeeming an open-ended fund if you deal directly with the fund company. Broker’s fees are so low that commissions may not be a big factor if you don’t trade CEFs too often, but they can add up for investors who, for example, have a set amount invested every month.
Unlike open-ended funds, about two thirds of CEFs borrow money on top of investors’ contributions to expand the portfolio. That increases returns if things go well and makes them worse if they go poorly.
[Read: The Ultimate Guide to Bonds.]
This is one reason beginners can trip up, says Michael Olivia, an advisor with WestPac Wealth Partners and Guardian, in La Jolla, California.
“Closed-end funds can invest in non-traded securities and employ large amounts of leverage,” Olivia says. “This can make it difficult for the average investor to decipher whether the fund is appropriate for them.”
CEFs can also be used for short selling, to profit on a drop in share price. You can’t do that with an open-ended fund.
The ICI says CEF investors tend to be more affluent than the average investor.
“The ideal investor for this type of product would be someone income-seeking with patience and a long-term outlook,” Rudow says. “Closed-end funds may not be ideal for investors looking for riskier investments” that offer bigger returns than safer ones.
“With the [CEF] market value largely driven by demand, rather than underlying asset value, short-term dips in demand can largely discount the fund share price,” Olivia says. “An investor should expect the market value to be volatile and have the financial ability to hold the position through down markets.”
Jeff S. Vollmer, managing principal of Hyde Park Wealth Management in Cincinnati, warns that today’s market conditions do not favor CEFs. He says that although growth-oriented stock CEFs focused on technology have done well recently, many are trading at a premium, while investors do better buying at a discount, which is more common after a market decline.
CEFs owning municipal bonds, gold and other precious metals have been doing poorly, he says. While that has produced some deep discounts, it would take a turnaround in those assets for their CEFs to pay off.
“Fixed-income CEF’s were fantastic as interest rates fell over the years, inflating the value of the assets therein and driving them to premium valuations,” he says, while noting that today’s rising interest rates threaten bond values in those CEFs.
He says that stock-oriented CEFs have plenty of risk, too.
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
“As we sit nine years into a bull market, at some point, equities will turn south and CEFs can be less liquid and so harder to get out of than other [indexed investments] and open-ended funds,” he says. “So, buyer beware.”
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Should Investors Be Open to Closed-End Funds? originally appeared on usnews.com
