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What Is a Closed-End Fund? Definition and Example

A closed-end fund can offer both risk and opportunity to investors. Here's how they work.

Closed-end funds still command significant attention in the investment world, even though they are in moderate decline lately.

Closed-end funds are investment vehicles with shares listed on multiple global stock exchanges, like the New York Stock Exchange and the London Stock Exchange, that essentially trade like stocks.

According to Statista, U.S.-based closed-end funds held $250 billion dollars as of the end of 2018, down from $276 billion in 2005.

Assets might be going up, if the past few months are any indication.

Data from Lipper Alpha Insight shows that for December 2019, 95% of closed-end funds held net asset values (NAV) in the black. Meanwhile, 94% of equity-based CEFs and 96% of fixed-income CEFs posted positive returns over the same timeframe.

What do closed-end funds do and why should investors pay close attention? Here’s a closer look.

Closed-End Funds Defined

A closed-end fund, also known as a closed-end company, is one of the primary types of investment companies, according to the U.S. Securities and Exchange Commission.

Here’s a list of “must knows” about closed-end funds that can help you decide if closed-end funds are for you.

Different Trading Options

The SEC defines closed end funds as closed funds that “generally do not continuously offer their shares for sale.”

Instead, closed-end funds sell a fixed number of shares at one time, via an initial public offering. Once the IPO closes, closed-end fund shares will usually trade on a secondary market, like the New York Stock Exchange or the Nasdaq Stock Market.

Pricing by Market

Price-wise, closed-end fund shares that trade on market exchanges is determined by that market, and can trade either above or below the fund’s net asset value.

Generally Not Redeemable

Investors do have limited options with close-end funds. For example, fund shares aren’t redeemable, meaning the closed-end fund company doesn’t have to repurchase shares from investors if they make a request to do just that.

Some closed-end funds, particularly so-called interval funds, may redeem shares but most closed-end funds won’t do so, and legally don’t have to do so.

Advisers as Managers

Closed-end fund management differs from regular mutual funds and exchange-traded funds, as well. Closed-end fund portfolios are managed by investment advisers known as “separate entities” by securities regulators. The investment adviser must, however, by registered with the SEC.

SEC Oversight

Like most funds that trade on open markets, closed-end funds are regulated by the SEC on behalf of the investing public.

According to the SEC, closed-end funds “are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act. Closed-end funds are also subject to the Securities Act of 1933 and the Securities Exchange Act of 1934.”

As an Income Stream 

More conservative investors turn to closed-end funds due to the reliable stream of income the funds provide. Yet unlike fixed-income interest payments, which are made twice a year, closed-end funds pay out quarterly or even monthly, making them a favorite for retirees and liquidity-minded investors, among others.

How Closed-End Funds Work

The best way to explain how closed-end funds work is to compare them to more traditional – and more common – mutual funds and exchange traded funds.

Traditional mutual funds are also known as “open-ended” funds, as shares of the fund are sold only by the mutual fund firm that offers the fund. Mutual funds offer unlimited shares to investors, which in most cases a positive outcome, especially if the markets are doing well and the mutual fund in question is in big demand.

If the opposite scenario occurs, and markets tank and mutual fund shareholders want to redeem their shares, that puts the mutual fund manager in a tough place. He or she has to sell in what could a be a sinking market to honor their obligations to shareholders who want to cash out. Additionally, the shareholders who remain in the fund are vulnerable to a heavy stream of redemptions, as other shareholders head for the hills.

Close-end funds don’t work like that.

Closed-end funds operate more like stocks or exchange-traded funds. They are introduced via an initial public offering and the funds accumulated through the IPO are put right to work by the fund manager, who is mandated to follow a narrow set of fund management guidelines.

After the IPO ends, the closed-end fund morphs into more of a stock than a fund, trading openly on secondary markets and are walled off from the redemption restrictions that mutual funds carry.

Closed-end funds do share some similarities to mutual funds.

For example, like mutual funds, closed-end funds come in kinds of investment categories, including stock market, bond market, international, emerging market, and blended funds, among others.

Investors count on closed-end fund managers to use their financial market expertise to generate positive gains that ideally outweigh similarly-classed ETFs and mutual funds. Closed-end fund managers are considered “actively-managed” fund experts and use their unique investment-picking skills to add value with positive fund performance.

An Example of a Closed-End Fund

While there is a wide variety of closed-end funds available on the open market, let’s pick one CEF to gain a better understanding of how a closed-end fund works.

Consider the Cohen & Steers Quality Income Realty Fund (RQI), which has $1.6 billion in assets and a NAV of around $14.75.

The fund has earned an annualized 10-year return of 19.2% as of the end of 2019, making it the top-performing closed-end fund over the past decade.

While real estate has been strong over the past decade, the fund managers have generated hefty returns by focusing on real estate investment trusts (REITs), mostly through the inclusion of common stocks, and a modest selection of preferred stocks.

Even though the robust returns have significantly boosted investor demands for the fund, RQI still trades at about a 4% discount, making it not only one of the best deals in the CEF sector, it’s also one of the best deals around overall.

Should You Invest in a Closed-End Fund?

In general, if you’re a more conservative investor who likes a fund with a good yield distribution, a closed-end fund could be for you.

Just note that closed-end funds are treated differently than open-ended mutual funds, especially on pricing and that once the initial IPO is finished, the fund won’t be creating any additional shares for sale to the public.

Just like any mutual fund, closed-end fund investors have to weigh the value of the stocks or bonds included in the fund. But CEFs add another layer of assessment, as investors must also weigh any potential discounted price, especially if the discounts shrinks, and must check the odds of the fund’s premium expanding – issues you don’t normally worry about with mutual funds or ETFs.

In general, if you prefer your funds to have share prices that trace closely with its net asset value, then closed-end funds may not be for you.

If you can live with more volatile share pricing, and value frequent distributions and a wide selection of closed-end funds on the market, then CEFs can easily find a home in your investment portfolio.