Closed End Funds: what the Heck are they?
Closed end funds are not the easiest concept to pick up by amateur investors. They are a little bit like stocks and a little bit like open-ended mutual funds (what most people commonly think of when they think of ‘mutual funds’). As such, they are a little off the beaten path for most investors. To understand what they are and how they are priced, you first have to understand how mutual funds work. Once you understand, you might be tempted to invest in them since they often trade at premiums or discounts to their values. If you’re an amateur investor, it could be a risky game to get into. They can also provide unique opportunities.
Closed End Funds vs. Open End Funds
Open-ended funds rule the mutual fund world. Most funds in your employer’s 401K fall into the open end category. When comparing open-end funds to closed-end funds there are two main factors to consider:
- How many shares there are.
- How they are priced.
How Many Shares
The first difference between the two is how many shares there are. Closed-end mutual funds are offered up in an IPO. This means that there is a set number of shares which are offered on a stock market. The number of shares does not change as a result of new investors putting money in the fund. If you buy shares, it’s because an investor was selling theirs. With open-end funds, on the other hand, there is a limitless number of shares. You do not need an investor to sell you their shares. You buy new shares, and new shares are created for you. There is no exchange of shares from one investor to another.
How Open Ended Mutual Funds are Priced
You may be wondering how the share price of open-end funds is calculated. Open-end fund share prices are bases solely on the net asset value (NAV). This is basically how much the total value of all its investments are worth, divided by the number of total outstanding shares. The NAV is the price you buy or sell a share at. This NAV is calculated at the end of each trading day.
How Closed End mutual funds are Priced
Much like with open-end funds, closed-end funds have a calculated NAV (total value of underlying investments divided by number of shares). However, this is often not what the shares are priced at. Since shares are traded on the open market, the shares can trade at a discount or premium to the actual NAV, based on perceived value of the investor.
Where can you Buy Closed End Funds?
Any old online discount broker provides a platform to buy and sell closed end funds.
Closed End Funds Trading at Discounts to NAV or Premium?
Common sense would lead you to believe that a closed end fund trading at a discount to its NAV would be a good buy. And especially one trading at a 5, 10, or 15% discount. Similarly, it would intuitively make sense that one selling at a 10% premium to its NAV would be ripe for selling.
So why do closed end fund prices vary so much from the NAV? That’s one of the true mysteries behind them – and probably a good reason why amateur investors should be careful in getting into that game. Who’s to say that a closed ended fund trading at a 5% discount to its NAV won’t end up trading at a 15% discount to its NAV? Not me.
The first difference between the two is how many shares there are. Closed-end mutual funds are offered up in an IPO.
is that right? Do you beleive that?