Picture taken in front of the offices of major closed-end fund
Adams Express. Source: Library of Congress.
Ask most investors what closed-end funds are, and you'll
probably get a lot of blank stares. Yet even though closed-end
funds aren't the most well-known investments available, they have
some true advantages over other types of investments that can
work in your favor.
Most investors know that mutual funds and exchange-traded
funds both offer opportunities for investors to diversify their
portfolios even if they only have modest amounts to invest.
Closed-end funds share many of the advantages of ETFs and mutual
funds, but they also have unique attributes that can be
attractive to many investors.
What are closed-end funds?
Closed-end funds are like mutual funds and ETFs in that they
are pools of investments in which shareholders each own a small
fraction of the overall fund. Most closed-end funds specialize in
certain categories of investments, so you can find funds geared
toward domestic or foreign stocks as well as fixed-income
investments of different varieties. Other closed-end funds use
more sophisticated tactics, such as covered-call options
techniques, to generate more income.
Closed-end funds trade on stock exchanges just like ETFs do,
giving investors the chance to buy or sell at any point during
the market day, as opposed to the once-daily trading and pricing
of traditional mutual funds. What makes closed-end funds
different from ETFs and mutual funds, though, is that closed-end
funds only have a fixed number of outstanding shares. As a
result, prices of closed-end funds don't always track the
underlying value of the investments they hold, which means their
shares often trade at premiums or discounts compared to their net
What is the history of closed-end funds?
Closed-end funds are much older than ETFs, having served the
purpose of providing instant liquidity for decades before the
explosion in ETF popularity. Closed-end funds have been around
for more than a century, with the first fund coming into
existence in 1893. But the Investment Company Act of 1940 helped
to popularize closed-end funds as well as traditional mutual
funds, as it created a way for fund managers to set up funds that
would comply with regulatory requirements. In addition, favorable
tax laws that eliminate double taxation and allow closed-end
funds to pass taxable income on to their shareholders made
closed-end funds more attractive as investments for ordinary
How many closed-end funds are there?
According to figures compiled by Aberdeen Asset Management, a
major closed-end fund provider, there are more than 600 U.S.
closed-end funds available in the market today. Although many
funds are relatively new and have limited track records, you can
find others with decades-long track records.
Why invest in closed-end funds?
Closed-end funds make useful investments for several reasons.
Unlike most ETFs, closed-end funds typically have actively
managed portfolios, rather than passively tracking an index. That
makes closed-end funds more expensive than many ETFs when it
comes to expense ratios and other management costs, but many
investors believe the dynamic portfolios that closed-end funds
offer are worth the additional cost.
Closed-end funds also offer exposure to underlying assets that
other investments don't. For instance, it can be difficult to
find options-oriented investments outside the closed-end
What really makes closed-end funds stand out from other
investments, though, is the opportunity to get funds' shares at a
discount to the value of their underlying assets. With some
closed-end funds, investors are willing to pay premiums above
their net asset value, often because it's difficult to buy the
underlying assets directly. For asset classes that are more out
of favor, discounts typically predominate. Yet in just about
every case, closed-end fund shares will see greater discounts at
certain times and smaller discounts or even premiums at other
Buying closed-end funds when their shares are particularly
cheap compared to their net asset value gives you the opportunity
to boost your total returns. Often, the underlying assets will
rise in value at the same time that the discount narrows or turns
to a premium. Therefore closed-end fund investors will get
outsize returns, because the narrowing discount will provide even
greater gains on top of the appreciation in the fund's
Similarly, buying closed-end funds at a premium can be
dangerous. If the underlying assets fall in value, and the
premium turns to a discount, shareholders can suffer much larger
losses than they would if they used other investment vehicles to
buy those assets.
Overall, closed-end funds are an excellent tool that smart
investors can use to broaden their investing horizons and gain
opportunities that others miss. Their quirks can take some
getting used to, but it's still smart to investigate closed-end
funds and see whether they deserve a place in your portfolio.
Closed-End Funds: Investing Essentials
originally appeared on Fool.com.
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