Closed-End vs. Open-End Funds

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 $6.2 billion "London Whale" trading loss that took place at JP Morgan in 2012 – sometimes complicated investments produce unexpected results. Many of the more complicated investment products are inappropriate for most 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?

Open-End Funds

Many investment products are not one single product, but are instead a collection of individual products. Just as you wear different pieces of clothing that 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 fund.

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 number 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 in the same way 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 number of shares bought and sold. Their price is based on the total value of the fund or the net asset value (NAV).

Closed-End Funds

Closed-end funds (CEFs) may look similar, but they're actually very different. A closed-end fund functions much more like an exchange traded fund (ETF) than a mutual fund. It is launched through an IPO in order to raise money and then traded in the open market just like a stock or an ETF. It only issues 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.

More than $260 billion is held in the closed-end funds market, yet it is not well known by retail investors. Some funds, like BlackRock Corporate High Yield Fund VI (HYT), pay a dividend of around 8%, making these funds an attractive choice for income investors.

Investors have to know a key fact about closed-end funds: Nearly 70% of these products use leverage as a way to produce more gains. Using borrowed money to invest can be risky, but it also may produce big returns. Closed-end funds had an average return of 12.4% in 2017, reports CEF Insider. And "many CEFs are poised to keep up the performance," predicts Michael Foster, the lead research analyst for Contrarian Outlook, in Jericho, New York.

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.