While closed-end funds share many traits with the more common open-end mutual funds, there are many distinctions between the two investment vehicles. Both are pools of assets that offer smaller investors the benefit of professional management and economies of scale. Both may be operated by the same managers and fund companies, and, for the most part, may invest in the same holdings.
How Closed-end Funds Differ from Open-End Funds
Closed-end funds differ primarily in their structure. Instead of issuing unlimited amounts of shares and redeeming them on demand, closed-end funds issue only a fixed number of shares at an initial public offering (IPO). These shares are then traded on the New York Stock Exchange (or occasionally on other exchanges or over the counter) and must be purchased through a broker. The fund's share price can then fluctuate and differ from the fund's net asset value (NAV). A fund selling for a price higher than its NAV is said to be trading at a premium; a fund selling for a price lower than its NAV is said to be trading at a discount. Frequently, new funds will begin trading at a premium, because the initial offering price includes underwriting costs in addition to the fund's assets. This premium often falls or disappears entirely in a matter of weeks or months, however, as investors seek to purchase the fund at a price closer to its NAV. Because all CEFs must be purchased through a broker, who charges a commission, the closed-end universe doesn't have "no-load" or "load" funds.
Advantages of Closed-end Funds
Closed-end funds offer several advantages. For one thing, they allow investors to buy assets for less than their true worth. A fund trading for a 10% discount, for instance, lets investors buy $1.00 worth of assets for only $0.90. If such a fund performs well, it might well move to a premium, allowing shareholders to reap the benefits of not only the fund's NAV advance, but the exaggerates effects of its market-price movement.
A closed-end fund's fixed number of shares also gives its manager a stable pool of assets to invest. Because shareholders cannot ask the fund to redeem their shares—and new investors cannot deluge the fund with money in exchange for new shares—the manager need not worry about having to raise cash at an inopportune time or having to invest vast new amounts of cash in a market that already seems pricey.
The stability of their assets bases make closed-end fund's the preferred vehicle of single-country funds. A new closed-end fund offers a country with a developing stock market the assurance that this large amount of foreign capital will not be removed, by shareholder request, at the slightest sign of political or economic uncertainty. Closed-end funds such as First Philippine and Pakistan Investment can guarantee a long-term commitment to a developing market that open-end mutual funds cannot match.
Changes in Closed-end Funds
Although a closed-end fund ordinarily has a fixed number of shares, it does have four ways to raise new capital. First, the fund can hold a rights offering, in which existing shareholders can purchase additional shares, usually at a discount to the fund's current market price. For instance, shareholders might be offered the change to buy one new share for every three they own. Second, the fund may engage in leveraging—borrowing money from a bank or issuing preferred shares. A fund engaging in this practice hopes to earn a higher rate of return from its investments that it is paying out in interest. Third, the fund may issue new shares that can be bought by new investors as well as exiting shareholders. Finally, the fund may turn itself into an open-end mutual fund and take in an unlimited amount of new assets.
A closed-end fund should not be confused with a closed fund. The latter is really an open-end mutual fund that has decided to stop taking in new money—whether temporarily or permanently—because its management thinks that its size is becoming more of a burden than an advantage.