A closed-end fund is a collective investment scheme involving a very limited number of shares. It is known as a closed-end fund because the shares are issued rarely once the fund has been launched. These shares are generally irredeemable against cash and securities till the fund liquidates.
Basically, an investor can get shares in a closed-end fund by purchasing shares in a secondary market from a market maker, broker or any other investor. The price of a closed-end fund is assessed partially through the value of investments in the funds and partially through the discount or premium over it in the market. The net value of all the assets in the fund is divided by the number of shares to calculate the net asset value (NAV) per share.
The price of a fund share in the market is usually lower or higher than the net asset value per share. In case the share price of a fund is higher than net asset value per share, it is known to be selling at premium, and contrarily, when the price is lower, it is known to be selling at a discount to the net asset value per share.
The returns that you collect on a closed-end fund are based upon the following:
ü The appreciation or depreciation of the share price of the fund
ü Dividend income from the interest and dividend payments the fund receives from the securities held in the fund’s portfolio
ü Recognize capital gains distributions, which might be distributed among the shareholders when a fund generates profits from selling the securities
These are legally called “closed-end companies” in the United States and form part of one of the four types of investment companies such as the Exchange Traded Funds (ETF’s), mutual funds and unit investment trusts. All of these are recognized by the Securities and Exchange Commission (SEC) in the United States.
Closed-end funds are usually sponsored by the funds management company. Such companies control the investment process very carefully according to market trends. They start by seeking money from investors in initial offerings that might be public or limited. The investors are offered shares according to their initial investment.
The fund managers pool all the money and buy securities. The investments made by the manager depend largely upon the fund’s charter. The managers make investments in different financial instruments such as bonds and stocks, and some even invest in particular things like tax-exempted bonds that are issued the state of Florida in the United States.
Closed-end funds pay off monthly or quarterly dividends to the shareholders. They are a very attractive substitute for people who are looking for more income. However, the share price sometimes can be highly unstable.
The share price turns unstable because most of the closed-end funds make use of leverage or borrow money against the fund to purchase more securities. The main purpose of doing this is to increase the return on the fund employed or the amount of money generated out of it.
When the fund trades at the discounted rate, it means that any share bought is purchased on a discounted price than the market value of all the underlying investments of the funds. Contrarily, when the fund is traded at a premium, it means that any share bought is purchased more than the market value of the all the underlying investments of the funds.