Closed End Mutual Funds Investment Basics Series
What do you know about closed end mutual funds? Should you invest in them? This investment basics article aims to provide you with enough information to answer these questions and help you with managing your personal finances a little better.
You may already be familiar with what mutual funds are, a group of stocks managed by an individual. What you may not have realized, is that there are two categories, open end and closed end mutual funds. While there are many similarities between the two, significant differences do exist.
Your understanding of these differences will greatly help you to make a more informed decision of whether either investment is right for your own portfolio.
1. New Capital
All open end funds gain and lose money (capital) on a continuous basis depending on the individual investors in the marketplace. These capital fluctuations make it more difficult for the fund manager to make longer term investment decisions, yet you as an investor have continuous access to purchasing and selling shares in the fund.
Closed end funds cut off any new investments after a specified dollar amount or time. The fund manager only has the capitol received with no new money coming in, except under limited conditions. There is an advantage to not having capital fluctuations such as the ability to take more risk with a chance for higher rewards (increased returns).
2. Trading Shares
Similar to a stock, both open and closed end mutual funds become available by a company and traded between investors. The difference lies in that an open end mutual fund is only able to be bought and sold (traded) at the end of the day, whereas the closed end funds are available for trading the entire day.
3. Pricing
An open ended fund is traded based on its net asset value (NAV), how much the fund is worth. This is based on the values of the individual investments the fund manager purchases including cash on hand and subtracting any fund debt.
This is called being sold at a premium or discount to its actual/perceived value. To the contrary, a closed end fund's price is based on the market, not the NAV (see Trading Shares above).
4. Using Unlisted Securities
There are a number of stock investments which are not listed openly on a stock exchange. This could be because the stock did not meet specific requirements or the company simply did not wish to conform to the restrictions that come from "being listed".
These unlisted securities are inherently riskier, but have the potential for greater returns. Closed end mutual funds tend to include unlisted securities more than open end funds do.
5. Leverage Used to Increase Returns
When closed end funds issue various investments such as preferred stocks, bonds, or other instruments, it is done with the intention of raising more capital, as new shares of the funds itself is closed off. This is a form of borrowing to fuel growth.
For an open ended mutual fund to raise new capital, it would need to sell more shares, diluting the individual value of existing shares.
6. The Real Advantage
Unlike the typical open end mutual fund, closed end funds have the benefit of a higher caliber professional management as well as better diversification with lower expenses. In addition, marketing and selling expenses of the fund are eliminated after the initial selling of the shares.
Remember that a uniqueness to this investment is no new shares may be sold. This results in lower operating or management fees, thereby increasing overall share value.
As closed end funds include both stocks and open end fund features, they do include inherently more risk with greater rewards, the bottom line question to ask yourself is, "Should I invest in closed end mutual funds?"
My financial investment advice is, "it depends." Sorry for the wishy washy answer but I do not know your particular financial situaion.
Your investment philosophy, temperament for risk, research, and exit strategy, all play a part in your decision. However, as a family financial coach I can unequivocally state that before considering closed end mutual funds or any other investments, common sense investment basics mandate that you must first be out of personal debt.
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