It’s easy to be overwhelmed by the sheer number of investment options available to you. The decision of where to invest is not easy, and it’s essential to study your options before making your choice.
One such option is a closed-end fund, and it could just offer the kind of diversification your portfolio needs.
What are closed-end funds?
A closed-end fund is an investment model that raises capital by offering a fixed amount of shares through an initial public offering.
After the fund reaches its fixed amount, a brokerage company licensed by the U.S. Securities and Exchange Commission (SEC) manages the money.
Unlike other types of investment models, like the more common open-end funds, a closed-end fund will not buy back shares from investors, but investors can trade entire closed-end funds on the market as if they were individual stocks.
How do closed-end funds differ from open-end funds?
Unlike open-end funds, closed-end funds only accept new capital through the initial public offering. Once they’ve collected this initial round of capital, investors can no longer buy in, but their shares can be traded on the open market.
As with regular stocks, the price of these shares fluctuates throughout the trading day according to supply and demand. This means that the price of a closed-end fund will often be different than the net asset value of the fund.
Meanwhile, open-end funds are traded only once a day, before the market closes, at a price reflecting their net asset value.
Is a closed-end fund right for you?
As with any investment, there are several risks associated with closed-end funds: Because the stock price is at the mercy of market forces, you can expect volatility, which could make them a poor choice if you’re a risk-averse investor.
But this higher level of risk also means that closed-end funds potentially offer a higher reward.
Flexibility is another factor: Because the fund doesn’t buy back shares, you won’t be able to liquidate quickly if you need to. This is important, because you may not want to get your money stuck in an asset when you could use the cash.
However, this very quality can also be an advantage: Closed-end funds don’t need to keep a great deal of cash in reserve for payouts, which frees up capital to be invested and create higher dividends for their investors.
Timing plays an important role as well. If you buy shares in a closed-end fund at the right time, there’s a good chance you’ll be able to pick them up at a discount and make a profit when the stock price eventually rises to meet the net asset value.
What kind of closed-end fund should you invest in?
There are a few things you should keep an eye out for: A younger fund is generally a riskier investment.
Try to invest in a fund that has been performing well for a few years under the guidance of a manager with a good reputation. A fund that has been in operation for several years under the same manager and has shown good returns is likely to be a solid bet.
While closed-end funds are designed to generate relatively higher income levels for investors, it’s important to ensure that the higher yield is not entirely the result of leveraged capital.
It’s worth checking whether the fund has overextended itself to avoid investing in a fund with an untenable amount of debt.
The bottom line
Your closed-end fund investment should offer you a better return than a comparable mutual or exchange-traded fund. However, you should also consider whether the taxes you’ll be required to pay on the higher returns and the fund’s fees and expenses will make your higher return negligible.
