What is a Closed-End Fund?

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Definition:

A closed-end fund is a professionally managed pool of investments, which sells a fixed number of shares and then stops accepting further investors.

🤔 Understanding a closed-end fund

A closed-end fund is technically an investment company that raises a predetermined amount of capital through an initial public offering (IPO). Once the IPO is over, the fund is closed. A new investor who wants to participate in the fund must buy shares from an existing shareholder on a secondary market, like an exchange. Open-end funds, on the other hand, continue to have capital flowing in and out throughout the life of the fund. While a closed-end fund raises a stable amount of capital through a IPO, an open-ended fund grows and shrinks as investors add and remove their capital.

Example

Credit Suisse, a financial services company based in Switzerland, sold shares of its high yield bond closed-end fund in 1998. Unlike with an open-end fund, investors can't buy newly issued shares from the institution to get access to the fund. Instead, they must buy existing shares from current shareholders.

Takeaway

A closed-end fund is like buying a limited-edition piece of art…

If there's an artwork you really like, you can ask the artist to make another piece for you. But sometimes that's not an option. Rather than making copies for everyone that wants one, the artist might only issue a certain number of prints. If people want a copy, they need to buy it from someone who owns one. Similarly, an investor wanting access to a closed-end fund must buy shares from someone who owns them, as the fund is closed to new capital.

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What is a closed-end fund?

Closed-end funds (CEFs) are investment structures in which investors purchase equity in an investment company. The investment company issues a limited number of shares in an initial public offering (IPO), then invests the raised capital in a portfolio of stocks, bonds, or other securities.

After the IPO, the fund is closed to new investors, and owners can't request their investment back from the investment company. Shares of a CEF get traded on an exchange, just like stocks. This means a CEF comes with the same types of risks as stocks, such as the share price going down. They also come with additional risks, since investors can’t just redeem their shares with the investment company. With an open-end mutual fund, investors can buy or sell additional shares directly from the investment company daily. But if they want to convert shares in a CEF to cash, they must find another investor to buy them out.

What are some examples of closed-end funds?

Closed-end funds (CEFs) come in all shapes and sizes, but all of them pool money from many investors. Each fund sets its own rules for the types of securities it buys. Some seek high returns by taking more risks. Others focus on stocks that pay high dividends. Here are a few examples of types of closed-end funds:

  • An emerging-markets CEF focuses its investment activity on companies in developing countries, attempting to gain value based on the growth of their economy.
  • A high-dividend CEF might invest exclusively in stocks that pay large dividends.
  • A high-tech CEF might focus on buying stock in technology start-ups, trying to get ahead of the next big thing.
  • A government bond CEF might focus its investments on bonds from municipal governments or the US Treasury.

How does a closed-end fund work?

A closed-end fund (CEF) is technically a type of investment company. The CEF holds an initial public offering (IPO) to raise the capital to invest. Then, fund managers use the capital to buy and sell assets in an attempt to earn profits for the owners. Later, profits are distributed to owners, kind of like other companies issue dividends.

After the IPO, traders can buy and sell shares of ownership in the CEF on an exchange, just like they buy and sell shares in a company on the stock market. However, CEFs aren’t companies that make products or offer services for consumers. They are exclusively investment vehicles for investors.

What is the difference between open-end funds and closed-end funds?

Both closed-end funds and open-end funds allow investors to pool their money and buy assets they couldn’t afford on their own. The difference lies in the structure of the fund. With an open-end fund, investors add to the pool when they buy in. The fund expands by issuing new shares and shrinks when investors redeem shares.

A closed-end fund (CEF) is like an open-end fund that doesn’t accept new investors after the initial public offering (IPO). Capital doesn't flow in and out of a CEF the way it does with an open-end fund. That's because a CEF doesn't let investors buy or sell shares of the fund directly from the investment company after the IPO. Instead, those who want shares must buy them from existing investors. While a CEF has a relatively stable amount of money to invest, the manager of an open-ended fund must always be prepared for an investor who wants to redeem their shares.

You can think of a CEF like a water balloon and an open-end fund like a swimming pool. You can't easily change the size of a water balloon once it’s tied. Likewise, the size of a CEF is hard to adjust. If someone wants to join in, they must buy shares from an existing shareholder. With a swimming pool, you can more easily change the volume of water by pouring more in or scooping some out. Likewise, investors can add or subtract capital from an open-end fund.

What is the difference between closed-end funds and mutual funds?

A mutual fund pools money together from many individual investors in order to invest it. This gives investors access to assets they couldn't afford on their own. A closed-end fund also gives investors a share in a portfolio of assets. However, a closed-end fund is structured differently from a traditional mutual fund. So, it’s not a special type of mutual fund — It’s something else.

With a closed-end fund, an investment company sells a fixed number of shares in the fund to investors. Managers of the fund have a relatively fixed amount of capital to invest over time, because investors can't withdraw money from the fund or buy in after the IPO — They can only buy or sell shares on an exchange. These shares are traded on a secondary market (a market in which investors buy and sell assets they already own, like the stock market). Some of the fund’s earnings are distributed to owners, and the value of the shares changes based on supply and demand.

A traditional mutual fund allows investors to keep buying and selling new shares over time. The number of shares in an open-end fund is unlimited and continually adjusts to reflect the varying amounts of capital in the fund.

A mutual fund's share price is determined by the net value of the fund’s assets, divided by the number of shares investors own. That price gets updated once a day to reflect the most recent market activity. Fund shares in a CEF, on the other hand, change hands at different prices throughout the trading day. So, the market price of a CEF is updated all day long.

What is the difference between closed-end funds and ETFs?

An exchange-traded fund (ETF) is a collection of securities, like stocks and bonds, typically tracking a certain index or focused on a common sector. For instance, a healthcare ETF might invest in a variety of healthcare companies, such as firms in the pharmaceutical, hospital, biotech, and medical supplies industries. This ETF would allow people to invest across a spectrum of the healthcare industry, instead of buying stock in a single healthcare company.

Like ETFs, closed-end funds (CEFs) can also focus on specific asset classes or industries. But ETFs, like mutual funds, are a type of open-end fund. That means investors can continue to buy and sell new shares in the fund over time.

What are the risks of closed-end funds?

Many closed-end funds (CEFs) are actively managed. Managers might invest in speculative companies that they expect will grow or buy bonds from corporations with lower credit ratings. They might try to time the market or include complex financial instruments in the portfolio. Shares in a CEF are also less liquid than those in most open-end funds. All of these factors imply a higher level of risk and potential volatility in a CEF than many other investments.

CEF managers can also borrow to increase the fund’s holdings, a strategy known as leverage. Doing so can result in greater returns if investments perform well, but also exposes the fund to more risk if they don’t.

In theory, a CEF could generate more significant returns than the stock market when times are good, but it could also result in more substantial losses when times are bad. Remember, past performance doesn't guarantee future results.

Are closed-end funds a good investment?

All investments involve risk, including the potential to lose your entire investment. A closed-end fund (CEF) is an investment option that could appeal to those looking for the potential for high returns and who are comfortable with sustaining large losses. Someone who has a lower risk tolerance may want to opt for investments that are less volatile and more liquid. Anyone considering investing in a CEF, or any other asset, should review the prospectus and consider whether the risks and potential rewards match their investment objectives.

How do you invest in closed-end funds?

You can invest in closed-end funds (CEFs) on many brokerage platforms the same way you can invest in stocks. After you open an account with the broker of your choice, you just have to locate the CEF you want to buy (you can search by ticker symbols, just like with a company). Some brokerages have tools to help traders sift through all of the different investments and find what type of investment they’re looking for. Once you've done your research and decide to invest in a CEF, you can place an order for shares in a CEF the same way you would buy shares of stock.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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