Investors often confuse closed-end funds with mutual funds. While there are similarities between both types of funds, there are several key differences.
Closed-end funds, like open-end (mutual funds), are investment companies that are managed by professional portfolio managers. Some key benefits of closed-end funds include the ability to generate total return through a combination of portfolio performance, dividends and distributions, and the opportunity to buy and sell shares in the market at advantageous prices.
Differences between the two types of investment companies are illustrated below.
Click on any of the key features below to learn the details that make closed-end funds important investment options.
Investment funds provide individual investors with access to professional portfolio managers that deliver low-cost, extensive investment research, trading and money management expertise typically unavailable to investors directly. A fund’s portfolio manager or investment team makes buy and sell decisions for a portfolio that contains a variety of securities and in accordance with the fund’s stated investment objectives.
Diversification refers to spreading risk across an investment portfolio. While diversification does not ensure a profit, nor guarantee against loss, it can help minimize the risk associated with significant market action of any one security. Both closed-end funds and traditional mutual funds offer investors the ability to relatively inexpensively buy and own a group of securities, helping to reducing the risk that comes with an overconcentration in a security.
Both closed-end funds and traditional mutual funds follow a stated investment objective, such as growth or income. While some funds have wide latitude when choosing securities in which to invest, other funds are far more specialized, and fund managers must follow a more strict investment mandate, such as investing only in Asia small-cap companies, long-term bonds or other single-asset class investments. When considering funds, investors should choose funds that match their individual investment objectives and risk tolerance.
Registered investment company products, like closed-end and mutual funds, have stated investment strategies. A fund’s investment strategy defines how it expects to accomplish its stated objective. For example, a fund with a growth objective might define a strategy with a greater allocation of small-cap stocks, whereas an income objective may define a strategy that has a larger allocation of bond or preferred stock investments.
Both closed-end funds and mutual funds can offer investors economies of scale with respect to fund operating costs, like accounting and portfolio management. These costs are spread across all investors, reducing the overall cost for each investor, when compared with the cost investors have when investing directly in securities.
Pooled investment companies, like closed-end funds and mutual funds, offer investors lower professional portfolio management fees than would otherwise be available to individual investors.
Both closed-end funds and mutual funds offer investors exceptional liquidity, as buying and selling shares of both types of funds is simple.
Closed-end funds and mutual funds are exempt from taxes at the fund level. Funds are required to distribute all net investment income and realized capital gains.
Investment funds distribute earnings to shareholders at regular intervals – typically monthly or quarterly – in two ways:
Pooled investment companies are governed by the Investment Company Act of 1940, which regulates fund structure and operations of funds. Closed-end funds and mutual funds are also subject to SEC registration and regulation, the Securities Act of 1933 and the Securities Exchange Act of 1934, which are all in place to protect investors.
Unlike mutual funds, which must continue to sell new shares to investors, or redeem investor shares, closed-end funds only offer shares during the fund’s IPO. After the IPO, closed-end fund shares trade on an exchange, where investors can buy or sell at prevailing market prices.
Closed-end funds trade on an exchange, where supply and demand influences fund share prices. As a result, closed-end funds frequently trade at share prices different from the fund NAV. Mutual fund share prices are determined solely by calculating the fund’s NAV.
Closed-end fund shares are listed on national exchanges, such as the New York Stock Exchange or the NASDAQ, and investors can buy or sell shares throughout the day. Market sentiment determines if closed-end fund shares trade at a premium (higher than NAV) or at a discount (less than NAV). Closed-end fund investors may be able to take advantage of these pricing differences to enhance investment performance. Investors can use limit orders (orders that specify a price) in an attempt to buy or sell shares at set prices. Unlike closed-end funds, mutual fund shares can only be purchased or sold through the fund company, which processes fund transactions at the end of the trading day, using the calculated NAV price.
Since closed-end fund shares trade throughout the day, share prices change in real-time, allowing investors to see the impact of market sentiment. Investors also have the ability to react quickly when decisions have been made to buy or sell fund shares. Unlike closed-end funds, mutual fund shares are only priced once per day, at the close of business.
Closed-end funds calculate NAV at the close of each day, just like mutual funds. Because closed-end fund shares trade throughout the day on a national exchange, share prices will fluctuate based on market supply and demand. This frequently results in closed-end fund shares trading at a premium (above NAV) or a discount (below NAV). Closed-end fund transactions will also include brokerage charges, such as commission. Unlike closed-end funds, mutual funds trade only at the NAV calculated by the fund each day.
A key difference between closed-end funds and mutual funds is that closed-end funds issue a fixed number of shares in an initial public offering (IPO), and once the IPO is completed, typically no additional shares are issued. Conversely, mutual funds offer new shares continuously as investors can purchase additional shares.
Closed-end funds can raise additional capital through a secondary offering or rights offering, whereby additional shares are issued at a set price. While the new shares can provide a benefit to investors in reducing the amount of expenses per share, it can also be dilutive (reduce ownership percentage) to existing shareholders.
Closed-end funds raise a set amount of capital through the fund’s IPO. This provides the portfolio manager with a fixed or stable base of assets from which to invest in securities. Having a stable asset base is an advantage to portfolio managers and shareholders alike. A fund manager can invest as opportunities arise, without needing to invest significant cash inflows at less-than ideal market prices, as happens with mutual funds. Unlike mutual fund managers, closed-end fund managers are not forced to sell securities from the portfolio to meet shareholder redemption requests and trigger potentially unfavorable tax consequences. A stable asset base also provides flexibility to funds that invest in highly specialized investments such as illiquid securities, emerging markets, venture capital, private equity, real estate and private placements.
Because closed-end funds trade on an exchange, investors can purchase any number of shares without a minimum required investment. Conversely, mutual funds impose a minimum investment to buy shares. Some funds require as little as $3,000, while others require a $100,000 minimum investment. Without minimums, investors are not forced to buy more of a fund than desired to meet an investment objective and strategy.
Closed-end funds can use leverage (borrowing funds for additional investments) to amplify investment performance by producing outsized gains or enhancing earnings. Mutual funds have a limited ability to use leverage, whereas closed-end funds have no restrictions. Funds can use leverage in two ways: borrow capital or issue preferred shares. If borrowing costs are lower than the net long-term interest rates earned by the portfolio and the markets are rising, then fund shareholders will see greater returns than they would had the fund not used leverage.
When funds use leverage, the NAV will be more volatile than funds that do not use leverage. If borrowing costs increase, making leverage less attractive, or the markets decline, fund returns may suffer as a result of the increased volatility.
Closed-end funds are not restricted from making investments in illiquid securities, those that trade with little or no volume. This provides portfolio managers with the flexibility to invest in less liquid companies, or in less liquid regions (emerging markets), where stronger growth potential may exist. Unlike closed-end funds, mutual funds are restricted by the Investment Company Act of 1940, which stipulates that mutual funds can only invest 15% of portfolio assets in illiquid securities.