Pros and Cons of Closed End Funds

by Kristen May

A closed-end fund raises a set amount of money by selling shares to investors through an initial public offering. That money is invested in an actively managed set of securities that are usually fairly narrowly defined. Once the initial offering is over, the fund is "closed" in the sense that new shares are not created. Instead, investors trade shares in the fund on the open market. Once the trading begins, the value of a closed-end fund's shares may rise above or fall below the underlying value of its investments as investors speculate on the direction of its overall fortunes.

Pro: Enhanced Value

The market value of the closed-end funds can rise above the value of the securities they hold as investors speculate on market trends. Closed-end funds sometimes gain this advantage because the types of securities they specialize in are expected to rise faster than the general stock market, or because their management team is particularly well-regarded, or because the fund is leveraged well, or a combination of all three. Whatever the reason, the market premium that traders will sometimes pay for closed-end funds can give the fund's investors greater gains than they could achieve by investing in the same basket of securities directly.

Pro: Pay Large Dividends

Closed-end funds have to distribute nearly all of their dividend and interest income to avoid federal taxation of the fund itself. This can make dividend-oriented closed-end funds particularly attractive to investors seeking income.

Pro and Con: Management Flexibility

The managers of closed-end funds never have to sell securities in order to redeem shares for investors. Because of this, they don't have to limit their investments to liquid, easily sold investments. This means they have the freedom to invest in harder-to-sell securities, such as stocks or debt instruments issued by very small companies. This can increase a fund's profitability if the investments are chosen well and managed well. But it can also limit a fund's ability to cut its losses if the investments fare poorly.

Con: Highly Leveraged

Managers of closed-end funds have a lot of freedom to take on short-term debt in an effort to boost profits, and many do. This kind of leveraged investing can boost profits sky-high when interest rates are low and the value of the fund's securities is on the rise. But rising interest rates can hurt returns, and an unexpected drop in security prices can devastate leveraged investments.

Con: Volatile Value

While mutual fund investments trade at their asset value, closed-end funds can vary widely from their net asset value. This can be good if you purchase a fund when it's below face value and sell it when it's above, but it can also lead your investment to tank more quickly.