New shares are rarely issued after the fund is launched; shares are not normally redeemable for cash or securities until the fund liquidates. Typically an investor can acquire shares in a closed-end fund by buying shares on a secondary market from a broker, market maker, or other investor as opposed to an open-end fund where all transactions eventually involve the fund company creating new shares on the fly (in exchange for either cash or securities) or redeeming shares (for cash or securities).
The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the net asset value (NAV) per share. The market price of a fund share is often higher or lower than the per share NAV: when the fund's share price is higher than per share NAV it is said to be selling at a premium; when it is lower, at a discount to the per share NAV.
In the U.S. legally they are called closed-end companies and form one of three SEC recognized types of investment companies along with mutual funds and unit investment trusts. Other examples of closed-ended funds are Investment trusts in the UK and Listed investment companies in Australia.
Like their better-known open-ended cousins, closed-end funds are usually sponsored by a funds management company which will control how the money is invested. They begin by soliciting money from investors in an initial offering, which may be public or limited. The investors are given shares corresponding to their initial investment. The fund managers pool the money and purchase securities. What exactly the fund manager can invest depends on the fund's charter. Some funds invest in stocks, others in bonds, and some in very specific things (for instance, tax-exempt bonds issued by the state of Florida in the USA).
Another distinguishing feature of a closed-end fund is the common use of leverage or gearing to enhance returns. CEFs can raise additional investment capital by issuing auction rate securities, preferred shares, long-term debt, and/or reverse-repurchase agreements, although this is rare in the USA outside of income-focused funds. In doing so, the fund hopes to earn a higher return with this excess invested capital.
When a fund leverages through the issuance of preferred stock, two types of shareholders are created: preferred stock shareholders and common stock shareholders.
Preferred stock shareholders benefit from expenses based on the total managed assets of the fund. Total managed assets include both the assets attributable to the purchase of stock by common shareholders and those attributable to the purchase of stock by preferred shareholders.
The expenses charged to the common shareholder are based on the common assets of the fund, rather than the total managed assets of the fund. The common shareholder's returns are reduced more significantly than those of the preferred shareholders due to the expenses being spread among a smaller asset base.
For the most part, closed-end fund companies report expenses ratios based on the fund's common assets only. However, the contractual management fees charged to the closed-end funds may be based on the common asset base or the total managed asset base.
The entry into long-term debt arrangements and reverse-repurchase agreements are two additional ways to raise additional capital for the fund. Funds may use a combination of leveraging tactics or each individually. However, it is more common that the fund will use only one leveraging technique.
Since closed-end funds are traded as stock, a customer trading them will pay a brokerage commission similar to one paid when trading stock (as opposed to commissions on open-ended mutual funds where the commission will vary based on the share class chosen and the method of purchasing the fund). In other words, closed-end funds typically do not have sales-based share classes where the commission and annual fees vary between them. The main exception is loan-participation funds.
Closed-end funds trade on exchanges and in that respect they are like exchange-traded funds (ETFs), but there are important differences between these two kinds of security. The price of a closed-end fund is completely determined by the valuation of the market, and this price often diverges substantially from the NAV of the fund assets. In contrast, the market price of an ETF trades in a narrow range very close to its net asset value, because the structure of ETFs allows major market participants to redeem shares of an ETF for a "basket" of the fund's underlying assets. This feature could lead to potential arbitrage profits if the market price of the ETF were to diverge substantially from its NAV. The market prices of closed-end funds are often ten to twenty percent higher or lower than their NAVs, while the value of an ETF would only very rarely differ from its NAV by more than one-fifth of a percent.
US closed-end stock funds often have share prices that are typically about 5% less than the Net Asset Value. That is, if a fund has 10 million shares outstanding and if its portfolio is worth $200 million, then each share should be worth $20 and you would expect that the market price of the fund's shares on the secondary market would be around $20. But, very oddly, that's typically not the case. The shares may trade for only $19 or even only $17. In the former case, the fund would be said to be "trading at a 5% discount to NAV." In the latter case, the fund would be said to be "trading at a 15% discount to NAV."
The presence of discounts is also puzzling since if a fund is trading at a discount, theoretically a well-capitalized investor could come along and buy up all the fund's shares at the discounted price in order to gain control of the portfolio and force the fund managers to liquidate it at its (higher) market value (although in reality, liquidity concerns make this impossible since the Bid/offer spread will drastically widen as fewer and fewer shares are available in the market). Benjamin Graham claimed that an investor can hardly go wrong by buying such a fund with a 15% discount. However, the opposing view is that the fund may not liquidate in your timeframe and you may be forced to sell at an even worse discount; but like any investment, these discounts could simply represent the assessment of the marketplace that the investments in the fund may lose value.
Even stranger, funds very often trade at a substantial premium to NAV. Some of these premia are extreme, with premia of several hundred percent having been seen on occasion. Why anyone would pay $30 per share for a fund whose portfolio value per share is only $10 is not well understood, although irrational exuberance has been mentioned. One theory is that if the fund has a strong track record of performance, investors may speculate that the outperformance is due to good investment choices by the fund managers and that the fund managers will continue to make good choices in the future. Thus the premium represents the ability to instantly participate in the fruits of the fund manager's decisions.
A great deal of academic ink has been spent trying to explain why closed-end fund share prices aren't forced by arbitrageurs to be equal to underlying portfolio values. Though there are many strong opinions, the jury is still out. It is easier to understand in cases where the CEF is able to pick and choose assets and arbitrageurs are not able to determine the specific assets until months later, but some funds are forced to replicate a specific index and still trade at a discount.
Some advantages of closed-end funds over their open-ended cousins are financial. CEFs' fees are usually much lower (since they don't have to deal with the expense of creating and redeeming shares), they tend to keep less cash in their portfolio, and they need not worry about market fluctuations to maintain their "performance record". So if a stock drops irrationally, the closed-end fund may snap up a bargain, while open-ended funds might sell too early.
Also, if there is a market panic, investors may sell en masse. Faced with a wave of sell orders and needing to raise money for redemptions, the manager of an open-ended fund may be forced to sell stocks he'd rather keep, and keep stocks he'd rather sell, due to liquidity concerns (selling too much of any one stock causes the price to drop disproportionately). Thus all it may have left are the dud stocks that no one wants to buy. But an investor pulling out of a closed-end fund must sell it on the market to another buyer, so the manager need not sell any of the underlying stock. The CEF's price will likely drop more than the market does (severely punishing those who sell during the panic), but it is more likely to make a recovery when the intrinsically sound stocks rebound.
Because a closed-end fund is on the market, it must obey certain rules, such as filing reports with the listing authority and holding annual stockholder meetings. Thus stockholders can more easily find out about their fund and engage in shareholder activism, such as protest against poor management.
Newer CEFs include: