What Are Closed-End Funds? A Simple Guide

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Closed-end funds, or CEFs, are mutual fund-like investments that trade on the stock exchange. They’re not as well-known as ETFs, yet they can offer unique benefits — like higher income potential — for hands-on investors.

They are called “closed-end” because they only issue shares to the public once, at the time of their initial public offering. After that, no investor money flows into or out of the fund. The only way to acquire shares is to buy or sell them with other investors in the open market.

How Are They Different From Other Funds?

Open-end funds are different in that they continually offer shares to investors who wish to purchase them. However, they’re only available directly from the mutual fund company, and they’re only priced once per day, at the close of the business day.

Exchange-traded funds, or ETFs, are something of a hybrid between CEFs and traditional, open-end mutual funds. ETFs trade on the open market, just like CEFs, but they continually offer shares to as many investors as are interested in buying them, as with open-end mutual funds.

Key Features of Closed-End Funds

Closed-end funds have certain traits that distinguish them from other types of investments, including:

• Fixed number of shares issued: Shares are only offered to investors during the IPO. If you want to own them afterward, you have to buy them from a seller on the open market
• Shares traded on stock exchanges like equities: Unlike with traditional, open-end funds, you can buy or sell shares in a CEF any time the market is open
• Market price may vary from net asset value: With an open-end fund, you buy and sell shares at the day’s net asset value. This is the total value of all assets in the fund divided by the number of shares in existence. As a CEF trades on the open market, though, the price you pay may be at a premium above or at a discount below what the assets within the portfolio are worth

How Closed-End Funds Work

Here’s the process of how closed-end funds become available for investors:

Launch and IPO Process

Closed-end funds raise capital and go public through an initial public offering, or IPO, just like a stock. Once the fund raises its initial money, it uses it to purchase securities in line with its stated investment objective.

From then on, the fund trades on the stock exchange without any additional investor money flowing into or out of it. Its share price will fluctuate in line with supply and demand, just as with any company’s stock.

Trading Mechanism

After the IPO, shares of a CEF are bought and sold on the secondary market only. It’s often easy to find out how much the fund was bought for during the IPO. However, once on the secondary market the price is usually totally different. It can be much higher or much lower.

Distribution of Income

Just as with an open-end mutual fund, a CEF is required to pass through at least 90% of its dividends, interest income and capital gains to its shareholders. Most funds pass through 100% of all income and gains to shareholders to avoid paying corporate taxes.

Types of Closed-End Funds

There are several different types of CEFs.

Equity CEFs

Equity CEFs focus on stocks. There are countless versions of equity CEFs, from those that own large-cap domestic stocks to those that own small-cap, mid-cap, foreign, emerging markets or other types of equities.

They can use different strategies to provide returns to investors, from the aggressive to the conservative, so be sure to read the fund’s information sheet before you commit any money.

Bond CEFs

Bond CEFs have an emphasis on fixed-income securities. As with equity CEFs, many different bond CEFs exist as well, from those that invest in conservative U.S. Treasuries to those that buy emerging-market or high-yield bonds in an attempt to achieve high returns. More than half of traditional CEF assets — about 60% — sit in bond-focused funds.

Specialty CEFs

If there’s an industry or sector you’re interested in investing in, there’s likely a CEF available for you. For example, you can buy a CEF that invests solely in real estate or one that purchases commodities like precious metals or raw materials.

Some CEFs use leverage, short sales or other advanced techniques to try to squeeze out the best returns for investors. It’s important to look beyond the stated objective of a CEF and analyze the risks that it may take before you invest.

How To Invest in Closed-End Funds

As with any financial investment, your first step before investing in CEFs is to take the time to research them. First, understand how CEFs operate in general, in terms of their net asset values and market prices. Then, look at a fund’s investment objectives and track record. If you can find one that meets your investment needs, fits within your personal risk parameters and is fairly priced, it’s likely a good option.

You can buy or sell CEFs on any major brokerage platform. If you need additional assistance understanding the risks and rewards of CEFs, consider working with a fiduciary financial advisor.

Key Metrics To Evaluate

Here are just some of the important factors you should consider when researching CEFs:

Distribution Rate

For many CEF investors, this is one of the most important metrics to evaluate. Although every income investor wants the highest payout policy, a CEF with a sky-high distribution rate might actually be a fund that is in distress or taking on excessive risk. This is why it’s so important to know what a CEF owns, how it’s operated and whether the distribution rate is healthy and sustainable.

Premium/Discount to Nav

If you pay a premium to buy a CEF, you’re paying more than the actual fund assets are worth. In most cases, this is an undesirable situation. However, some investors are willing to pay a premium on a CEF if it has a demonstrated track record of outperformance.

When you buy a CEF at a discount, you’re getting a bigger slice of assets than you’re paying for. This can boost the income-generating aspect of a CEF, but it can also indicate trouble with the fund or a lack of confidence from investors. As many as 60% of CEFs traded at a discount to NAV in 2024.

Many investors look at the long-term average of a fund’s premium or discount to determine if a CEF is currently under- or overvalued.

Expense Ratio

The expense ratio refers to how much it costs to own a CEF. The expense ratio covers everything from administrative expenses to manager salaries. The bigger the expense ratio, the more money that’s taken out of the fund’s profits. In most cases, you’ll want to find a CEF in your chosen investment class that has a lower expense ratio.

Closed-End Funds vs. Open-End Funds and ETFs

When To Consider Closed-End Funds

Although there are many different types of closed-end funds, they:

• Are often sought after by investors who want an income from their assets
• Don’t continually issue and redeem shares, so they don’t need to keep cash reserves on hand to meet redemptions, and they are often highly leveraged. This means most of the funds have been loaned out for other investments
• Often trade at a discount, allowing them to pay out a greater amount of income on a relative basis to shareholders.

All of these factors can significantly boost the income they pay out vs. traditional mutual funds.

However, the same factors that can enhance CEFs’ income-paying ability can also make them riskier.

• Unlike bonds, CEFs have no maturity date, so there is no guarantee of a return of principal.
• The use of leverage also works both ways, and it can hurt the value of a CEF if the market turns against it.

This makes CEFs best suited for income investors with a long-term perspective and a higher tolerance for risk.

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