A mutual fund is a collective pool of funds from individual investors that is assembled and managed by an investment management team. Closed-end funds invest funds like traditional open-end funds, but act more like stocks. Closed-end funds do not have a continuous offering of shares, like open-end funds, but rather have one initial offering of shares, after which the shares trade between individual investors, rather than between the fund company and the public. While closed-end funds have greater liquidity than open-end funds and typically enjoy lower annual expenses, they have some disadvantages as well.
Supply and Demand
Closed-end funds trade like stocks on an exchange, such as the New York Stock Exchange. As such, the price of a closed-end fund is dictated by investor sentiment, rather than the value of the underlying assets. Open-end mutual funds, unlike closed-end funds, are priced once per day at their true net asset value. Investors who wish to buy or sell an open-end fund must accept the price of the underlying assets as their value. Closed-end fund investors, on the other hand, have to accept what the current market price of the closed-end fund stock is, as opposed to the net asset value. Thus, in a thinly traded market downswing, in which many investors are selling and there are few buyers, the price of a closed-end fund may drop precipitously, even if the value of the investments within the fund remains firm.
Leverage
Most closed-end funds use leverage to enhance their returns, which works fine when the market goes up, but amplifies losses when the market goes down. Fund managers who use leverage borrow a percentage of the fund's assets, usually up to 33 percent of the total fund value, and use this borrowed money to purchase additional securities. If a general market fund is leveraged an additional 33 percent, that means if the stock market falls by 15 percent, the assets in the fund will fall approximately 20 percent.
Commissions
Some open-end funds have a sales fee charge, but it's only when you buy or sell, never both. Closed-end funds, on the other hand, generally require you to pay a commission both when you purchase them and when you sell them.
Discounts and Initial Public Offerings
Most closed-end funds trade at a discount to their net asset value, meaning their stock price is below the value of the investments in the fund. However, when closed-end funds are first issued to the public, they are priced either at or slightly above their net asset value. As a result, the value of closed-end funds usually falls shortly after their initial offering.
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