Closed-End Vs. Open-End Funds

By Tim Parker | June 27, 2012 AAA

Wall Street can be a complicated place. It's full of products that even some of the experts don't understand and, much like the recent events that took place at JP Morgan, sometimes complicated investments produce unexpected results. Many of the more complicated investment products are likely inappropriate for retail or part-time investors, but that doesn't mean that stocks and mutual funds are all that are available to you. Have you considered closed-end funds?

SEE: Open Your Eyes To Closed-End Funds

Open-End Funds
Many investment products are not one single product, but are instead a collection of individual products. Just as you wear a collection of clothing products to make up your whole wardrobe, products like mutual funds and ETFs do the same thing by investing in a collection of stocks and bonds to comprise the entire look.

There are two types of these products on the market. Open-end funds are what you know as a mutual fund. They don't have a limit as to how many shares they can issue. When an investor purchases shares in a mutual fund, more shares are created, and when somebody sells his or her shares the shares are taken out of circulation. If a large amount of shares are sold (called a redemption), the fund may have to sell some of its investments in order to pay the investor.

You can't watch an open-end fund like you watch your stocks, because they don't trade on the open market. At the end of each trading day, the funds reprice based on the amount of shares bought and sold. Their price is based on the total value of the fund or the net asset value (NAV)

SEE: When To Sell A Mutual Fund

Closed-End Funds
Closed-end funds look similar but they're very different. A closed-end fund functions much more like an exchange traded fund than a mutual fund. They are launched through an IPO in order to raise money and then trade in the open market just like a stock or an ETF. They only issue a set amount of shares and, although their value is also based on the NAV, the actual price of the fund is affected by supply and demand, allowing it to trade at prices above or below its real value.

There are currently about 650 closed-end funds trading on the market, yet they are not well known by retail investors. Some funds, like BlackRock Corporate High Yield Fund VI (HYT), pay a dividend of more than 8%, making these funds an attractive choice for income investors.

But investors have to know one key fact about closed-end funds. Nearly 70% of all of these products use leverage as a way to produce more gains. Using borrowed money to invest may produce big returns, but it could also put the fund under intense pressure. Recently, Moody's downgraded the rating of many of the largest banks that included debt securities issued by 38 closed-end funds.

These downgrades will likely make it more expensive for these and other closed-end funds to borrow money in order to invest. Higher borrowing costs impact the return investors receive from these funds, making them potentially less attractive in the future.

SEE: Leveraged ETFs: Are They Right For You?

The Bottom Line
Open-end products may represent a safer choice than closed-end funds, but the closed-end products might produce a better return, combining both dividend payments and capital appreciation. Of course, investors should always compare individual products within an asset class; some open-end funds may be more risky than some closed-end funds.

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