We have discussed in some detail mutual funds and the advantages they have from allowing diversification without researching a bunch of companies to the advantage of having professionals managing those funds. What I haven’t talked about are two types of mutual funds, open-ended and closed-ended funds.
Most people are more familiar with the open-ended funds. Those are funds that are bought directly from the company that is managing the fund. They are known as open-ended funds because the company can add more stocks to the fund as more investors become interested. Simply put, if there are 300 shares of company A, 300 of company B and 400 of company C, the managing firm can add more shares of the individual companies to accommodate new investors. (Very oversimplified, but I’m sure you get the point.)
On a closed-ended fund, there are no new shares of the fund being created in this fashion. Again, over simplified, but for example, 1000 shares of the closed-ended fund are available and are purchased by investors in an initial offering. These shares are traded, much like stocks on the open market. If a new investor is interested in that fund, he or she must buy the shares from one of the current owners, because the managing firm does not have the option of issuing new shares. The other factor is that the funds are only going to be around for a pre-defined number of years and then the assets are divided between the shareholders. This gives the fund manager a long term window with a defined amount of capital. Thus the manager can really look at the long term and not have to worry so much about short term fluctuations in price.
The question you probably have is; why would anyone invest in these, or what is the advantage to this type of fund? One answer would be that these funds are more actively managed. As stated above the fund manager can look at trends in the future and not have to be as concerned with the short term. For investors who are looking for more stability and a regular return this type of fund may be for you. Some investors don’t like the closed-ended funds because they are less liquid than the open-ended; at least in the ability to return the actual asset value.
What do I mean by that? These funds are often judged by their net asset value, abbreviated NAV. (NAV for a closed fund is determined by dividing the value of the stocks that make up the fund by the number of shares in the fund – the number of shares is a constant, as we discussed earlier.) Because you can sell your open-ended funds back to the managing firm for the value of the stocks that make up the fund, the NAV is always the exact price of those stocks. However, because you are at the mercy of the market with closed-ended funds, sometimes the price of the fund does not accurately reflect the stocks that make up the fund.
If a closed-ended fund is doing well, the NAV might be lower than the price of the fund shares. The fund is then said to be valued at a premium, if the NAV is higher than the current price; the fund is said to be at a discount.
What does all this really mean to you? If you are a patient investor, and have time to let your investments mature, a closed-ended fund may be for you. If you are considering investing in one of these funds, one that is selling at a discount can give you some immediate gain on paper. A discount closed-ended fund is like buying stocks ‘on sale’ if you are willing to hold on to them. As a fund approaches the end of its’ pre-designated lifespan, the NAV of a closed-ended fund will more accurately reflect the price of the stocks that make up the fund.