What Are Closed End Mutual Funds And How They Work

Unlike what the name suggests, a closed end mutual funds are not mutual funds, and are different from them in more ways than one. However, due to certain similarities between mutual funds and closed end funds, general public knows these as closed end mutual funds.

Closed end funds, like mutual funds, collect the assets of number of investors into a single portfolio to be invested into various markets. Closed funds are also required by regulations to divide the dividends and capital gains yearly. However, while open end funds can be directly bought and sold from the mutual fund company at the NAV, closed end funds are only launched once in the form of an IPO (Initial Public Offering) in the form of fixed number of shares. Public can buy these shares from the fund issuing company only at the time of an IPO. All later trading of these shares is done like normal stocks, where an investor buys certain number of stocks from the seller but not from the stock issuing company. Thus closed end funds do not sell at NAV like open end funds, but these sell either at a discount (trading price lower than the NAV) or at a premium, (trading price higher than NAV).

When a closed end fund is launched in an IPO by issuing a fixed number of shares, the Securities and Exchange Commission acts as a regulator, and requires that the IPO investors receive a prospectus containing all relevant disclosure information. The fund managers collect the funds acquired during the IPO, and then invest it according to the funds policies. The shares of such funds are then traded on the open market by investors. Closed end funds are better to manage from a managers point of view, as investor’s activity on the open market has no impact on the amount of funds available to invest.

As the closed end funds are traded on exchanges, its price can vary from its NAV. The price of such funds can seem to be irrational, as it might be totally out of line with its underlying securities which results in its NAV. As an example, Morgan Stanley Eastern Europe Fund (RNE) was trading on NYSE at a premium of 39% in May 2066, while it was selling at a discount of 6% in October 2006. Both these prices were different from its NAV, and such swings in its traded values are difficult to explain, as it depends on many of the market factors, some of which like investor’s confidence in the fund are not easy to measure. A smart investor can buy such shares when they are selling for a discount, and sell for handsome profits if and when they sell at a premium. However, its swings are not so easy to judge and they can take even a seasoned investor by surprise.

Closed end funds are not very famous and are usually preferred by only sophisticated investors. This in spite the fact that closed end funds have been around since 1893, which is more than 30 years before open end mutual funds hit the market. Today there are less than 1000 closed end funds in the market place, while the same figure for open end mutual funds is 8300. The probable reasons for their lack of popularity is that they are comparatively complex vehicles of investment, which are less liquid and more volatile when compare to open-end funds.