Closed-End Funds: A Comprehensive Guide to Potential Gains

The first step to understanding how to gain with a closed-end fund is to distinguish between this type of investment and a traditional mutual fund, also known as an open-end fund. Each type of fund offers you certain advantages based on unique structural differences. Additionally, there are another set of similarities and differences between a closed-end fund and an exchange-traded fund (ETF) that should be considered as well. Determining which investment type best suits your needs is an important step that should be completed before any capital is invested.

The Mechanics of a Closed-End Fund

A closed-end fund is an investment vehicle that issues a set number of shares and then allows those shares to trade in the secondary market. They are valued as a combination of the net asset value (NAV) of the securities held in the fund plus or minus a premium or discount. These funds trade continuously throughout the day, so the discount or premium is determined by market factors. This level can cause the trading price to be dramatically different from the NAV, and a given fund may swing from a premium to a discount at any time. The level of the premium or the discount is often difficult to understand based on the NAV, so you should not expect a clear path from the NAV to the price.

Finally, a closed-end fund may employ leverage to enhance returns, so you need to do a comprehensive risk analysis before investing. This can lead to greater returns, but the risk may increase as well. Additional yield enhancement may be achieved through the issuance of debt securities or preferred shares backed by the fund.

Closed-End versus Open-End Funds

Some of the clearest differences that you will see are that open-end funds trade only once per day and always trade at their NAV. An open-end fund's trading at NAV means that you will never pay a premium or receive a discount. When the fund experiences additions or redemptions, shares are created or destroyed in line with prevailing demand.

Closed-End Funds Versus ETFs

While both of these investment vehicles trade continuously through the day, the premiums and discounts that you will see in a closed-end fund are rarely present in an ETF. This is driven in part by the fact that closed-end funds may use leverage and in part by the fact that many ETFs allow large investors to redeem shares for a corresponding number of shares in the constituents of the underlying index. If large premiums or discounts occurred, arbitrage opportunities would be created and the gap would close quickly.

How to Make Gains in a Closed-End Fund

Given the mechanics of a closed-end fund, you can realize a gain in this type of investment in two related ways. First, if the assets held by the fund appreciate, the NAV contained inside the fund will rise in value. Secondly, if demand for the fund rises, the premium and thus the trading price of the shares will rise. If the shares are sold at this higher price in the secondary market, you will realize a profit.