A Little Bit Stock, a Little Bit Fund

What are closed-end funds, and how do they work?

QUESTION: Can you provide an explanation of closed-end funds?

ANSWER: Closed-end funds are a kind of mutual fund that behaves like a stock. Like their traditional mutual-fund siblings, closed-end funds hold baskets of securities, so you get diversification with a single share. But while an open-ended fund theoretically has a limitless supply of shares available, closed-end funds have a fixed number, which means they trade more like a stock than a fund.

Before we get into how a closed-end fund's shares are priced, bear with us while we review the pricing of a traditional mutual fund. With an open-ended fund, shares are priced according to the fund's net assets — that is, the value of all the stocks or bonds in its portfolio — divided by the outstanding number of shares. This is called the net asset value, or NAV. Shares are created or redeemed to suit investor demand — and while the fund's total assets can change as investors buy or sell more of its shares, that has no effect on the NAV. An open-ended fund is priced only once a day, after the end of trading, when the value of the portfolio's holdings is calculated.

Closed-end funds work differently. These funds have a limited number of shares, which are typically offered to the public during an initial public offering. The price of closed-end fund shares subsequently reflects the demand for the shares themselves on an exchange, where they trade continuously, just like stocks. And while a closed-end fund still has a NAV, each share can trade for substantially more or less than the value of the underlying portfolio. For example, the Jardine Fleming India fund (JFI) had a NAV of $8.32 as of last Friday, but traded at $6.80. So in this case, the shares are trading at an 18.27% discount to the fund's net asset value.

For a variety of reasons, most closed-end funds have historically traded at discounts, says Brian Smith, executive director of the Closed-End Fund Association. Because of this, some investors see these funds as a good value investment. They pick up closed-end funds trading at a discount in the hope that the fund will eventually trade at its asset value or even at a premium. A rise in price might happen when a particular asset class becomes hot or if there's a good manager at the helm who has racked up an impressive track record, says Don Cassidy, a senior analyst at Lipper.

These days, however, steep discounts are hard to find. "Over the last two years, discounts have narrowed in the closed-end-fund area. It's been a good couple of years for closed-end-fund investors," says Smith. Back in 1999, the average closed-end fund was trading at a 10% discount, according to Lipper. These days, the discount has narrowed to 4.6%.

As you can probably tell, this is pretty confusing stuff — which is why we don't recommend this type of fund for the novice investor. But sophisticated investors should still be able to find some good bargains in this group. If you do decide to invest in a closed-end fund, you should use some of the same criteria that you'd use to find a good open-ended fund, says Smith, such as the fund's performance record, the fee structure and whether or not the fund's objectives fit into your own investment portfolio and asset-allocation plan. But you also need to understand how the fund's share price relates to its underlying value and evaluate whether that price is appropriate. And that can be pretty tricky business.

For more on the basics of closed-end funds, see our story. And for a more sophisticated analysis, see Jonathan Hoenig's column from earlier this year.