Most mutual funds are open ended, which means the investment company can issue and redeem fund shares to meet investor demand. By contrast, closed-end funds issue a fixed number of shares in an initial public offering (IPO), and investors who want to purchase shares after the IPO must do so on a secondary market, such as the New York Stock Exchange. In this regard, closed-end funds are more similar to stocks.
Closed-end funds are much less common than open-end funds and tend to be favored by more affluent investors, including many retirees (see chart). This interest is likely due to the potential for a regular income stream — called the distribution rate — that may be higher than what might be obtained from a traditional mutual fund holding similar securities.
Unlike open-end funds, closed-end funds do not have to maintain cash reserves or sell securities to meet redemptions, so fund managers can invest in less-liquid securities and use leveraging methods usually avoided by mutual funds. This approach may provide higher income but is associated with higher risk and volatility than open-end mutual funds.
Distributions from closed-end funds can come from three possible sources: income distributions, including payments from interest and dividends; realized capital gains; and return of capital. Distribution rates are not guaranteed and can be increased or decreased in response to market conditions.
A healthy fund may return capital occasionally for a variety of reasons that should not be a serious concern for investors. However, consistent return of capital to maintain distributions that cannot be maintained otherwise — called destructive return of capital — is generally a sign of fundamental weakness in the fund.
Premiums and Discounts
The market price of closed-end fund shares trading on a secondary market is determined by supply and demand, not by the net asset value (NAV) of the shares. The trading price may be higher or lower than the NAV. If the price is higher, shares are selling at a "premium." If the price is lower, they are selling at a "discount." Although buying at a discount may be appealing, a lower discount does not necessarily make a fund a better value. It's important to understand the reasons for the valuation and assess the likelihood that the fund may meet its objectives, including any potential income stream.
Closed-end funds incur broker trading fees and charge management fees. They are generally not redeemable; the investment company does not have to buy back shares to fulfill investor demand. The value of all investments fluctuates with market conditions. Shares, when sold, may be worth more or less than their original cost.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
This information is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2019 Broadridge Investor Communication Solutions, Inc.