Why Investors Should Know About Closed-End Funds

By Mark Jewell, AP Personal Finance Writer

BOSTON (AP) — Despite their exclusive-sounding name, closed-end funds don't maintain the equivalent of a velvet rope restricting access to VIPs.

The reality is that investors in closed-end funds tend to be wealthier than the average client in conventional open-end mutual funds, which far outnumber closed-end funds.

Yet it's not a matter of cost that gives closed-end funds their more exclusive reputation. It's the difference in how closed-end funds operate that introduces an extra layer of potential risk, and draws a different pool of investors.

With closed-end funds, managers sell a fixed number of shares when the fund launches in an initial public offering, and typically don't issue more if new investors want in. Through a broker, new clients must buy from an existing shareholder willing to sell.

Compare that to regular mutual funds, where the fund company continuously lets investors buy or sell their stakes. Managers balance the fund's cash flow through buying and selling stocks or bonds, so the fund expands or contracts as needed.

"Closed-end funds tend to draw the more savvy investor, and that's probably how it should be," says Tom Roseen, a fund analyst with Lipper Inc. "The investor who does well with them is someone who really pays attention."

That means understanding that demand for a closed-end fund's fixed number of shares will shift. It's reflected in the discount new investors can get when a fund's shares are trading below the current market value of the stocks or bonds the fund holds. But if the secondary market favors sellers, buyers may have to pay a premium above the fund's net asset value.

This difference can add up to magnified gains or losses. That's because the discount or premium adds another variable influencing returns, beyond how much the fund's assets may appreciate, and the expenses you pay to invest.

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