Closed-End Funds: How They Work, Risks and How to Invest
Closed-end funds are a lesser-known kind of mutual fund. The best odds of success may come when buying at a discount.
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Closed-end funds, or CEFs, are investment companies that are managed by investment firms.
Closed-end funds raise a certain amount of money through an initial public offering.
Like mutual funds and ETFs, closed-end funds invest in a basket of securities.
A closed-end fund, or CEF, is a type of mutual fund that pools investor money via an initial public offering, or IPO. Like other mutual funds and ETFs, closed-end funds invest in a basket of securities. However, closed-end funds don't buy shares back from investors.
A closed-end fund is one type of mutual fund; an open-end fund is the other. Open-end funds are more common and are what investors are typically referring to when they discuss mutual funds.
Closed-end funds vs. open-end funds
The main difference between a closed-end fund and an open-end fund is that open-end mutual funds buy back shares when investors are looking to sell. Closed-end funds do not .
Open-end funds can sell as many shares to investors as they want. However, they sell shares only at the fund’s net asset value (NAV) per share.
The NAV is the market value of the fund’s holdings, minus any liabilities, divided by the number of shares. For example, if a fund has net assets of $100 million and 5 million shares, the price per share (the NAV) is $20 ($100 million divided by 5 million).
At the end of each trading day, the fund calculates its net asset value, and new investors can buy the fund’s shares at that price.
The fund puts that money to work by buying new securities — stocks or bonds, for example. This practice prevents new investors from diluting the holdings of the fund’s current investors.
Open-end funds are common in employer-sponsored 401(k) plans.
Closed-end funds sell a fixed number of shares during their IPOs.
Investors can buy and sell shares throughout the day, and the fund’s price fluctuates like a stock.
A closed-end fund’s market price can be the same as or higher or lower than its net asset value per share.
Pros and cons of closed-end funds
Closed-end funds are much less common than open-end funds, and they have some other features and risks not usually found in open-end funds.
Dividends.
Potential gains.
Fees.
Leverage.
Advantages of closed-end funds
Dividends
Closed-end funds tend to pay out relatively high dividends to investors in part because they use leverage to help boost returns.
Potential gains
Because they trade throughout the day, closed-end funds can trade below their net asset value for a long time — and they often do. But that also can be an opportunity for a smart investor.
Disadvantages of closed-end funds
Fees
Because closed-end funds are often actively managed by an investment manager who is trying to beat the market, they may charge relatively high fees.
Leverage
Closed-end funds frequently borrow money to fund their asset purchases. That strategy is a double-edged sword: It can improve returns when investments are rising but may magnify losses when stocks are falling.
Types of closed-end funds
There are four types of CEFs.
Traditional closed-end funds. These funds raise capital from investors via an IPO and then invest the money in various ways. Their shares may be worth more or less than the NAV at any given time.
Interval funds. These CEFs actually do offer to buy back some shares from investors from time to time (typically in three-, six- or 12-month intervals). This can provide liquidity to investors. Usually the fund repurchases the shares at their NAV less a redemption fee. The fund’s prospectus lays out the details.
Tender offer funds. These funds are sold to accredited investors or other qualified investors. They repurchase shares, but they do so on a discretionary basis through an SEC-compliant tender offer.
Business development companies (BDCs). These complex CEFs invest in small- and medium-size businesses. Some invest in private credit loans.
Buying closed-end funds at a discount
The best odds of success may come when buying a closed-end fund at a discount to its net asset value. Many funds trade at discounts and the investment manager publishes the fund’s net asset value quarterly or monthly.
If a CEF’s trading price is lower than the net asset value, the fund is trading at a discount.
Many investors aim to buy closed-end funds at a substantial discount. How substantial? It’s not uncommon for funds to trade at 10% or even 15% below their net asset value. It might not sound like a lot, but that kind of discount may be a built-in edge on the market. Not only could the fund’s holdings rise in value, but also the discount to net asset value may decrease.
How to buy closed-end funds
You can buy closed-end funds through a brokerage account. (We have a list of the best brokers for mutual funds.) You’ll want to consider:
Does the investment suit your risk tolerance, asset allocation needs and financial goals? If you’re unsure, talk to a qualified financial advisor before investing.
What kind of fund do you want? U.S.-only stocks? Dividend stocks? International stocks?
What is the performance over time? You can find long-term fund performance at most financial websites. Keep in mind that past performance doesn’t guarantee future results.
What is the fund’s typical discount to net asset value and its current discount? This provides you with an idea of how much the discount might decrease.
What is the fund’s expense ratio? This will usually be higher than for an open-end fund, so beware of sticker shock.
What kind of dividend does the fund pay?
How much leverage (debt) has the fund taken on? Too much debt makes the fund riskier.
Alternatives to closed-end funds
While all investments come with some form of risk, closed-end funds carry more risk than others. Many investors might feel more comfortable investing in an ETF. ETFs trade throughout the day, like a closed-end fund, but they tend to track a market index, such as the S&P 500, which is an index of large U.S. companies. This means ETF management fees are often lower — any difference in fees goes right back into investors' pockets.