Close-end Mutual Funds Explained

Under the Investment Company Act of 1940, the companies that operate mutual funds are called management companies and are classified in open-end investment companies, commonly referred to as mutual fund companies, and in closed-end investment companies, typically referred to as closed-end funds.

Closed-end funds make one-time offering of shares to investors through an initial public offering (IPO). After the offering, the securities are traded like stocks, but they cannot be redeemed by the company. Investors go through a brokerage firm to trade shares on any exchange and the market price of the fund's shares is determined by supply and demand. The money collected from the initial public offering is used to purchase a portfolio of securities that should reflect the particular investment objective of the fund as advertised in the fund's prospectus.

Typically, a closed-end mutual fund needs less money than an open-end fund to be managed because fund managers do not deal directly with individual investors in the form of sending interim statements or any other type of information. Besides, as closed-end investment companies are not required to redeem their shares back from investors, they are not also responsible for paying the investors who want to cash out their funds like it occurs in mutual fund companies. Therefore, a closed-end fund can be fully invested as it requires a small amount of cash and it is tax efficient.

Closed-end funds are also allowed to invest in a larger amount of illiquid securities than are open-end funds. Because of this feature, closed-end funds invest in markets where securities are rather illiquid, meaning they cannot be sold within seven days at the fairly accurate price used by the fund to determine the Net Asset Value ( NAV ) of the fund.

The Net Asset Value of a closed-end fund is calculated twice daily based on prevailing market prices for the securities in the portfolio. However, the Net Asset Value of a closed-end fund and its market price are never the same. On a long-term horizon, the market price of a closed-end fund is between 5 and 20 percent below its Net Asset Value, and therefore, the market price of a closed-end fund sells at a discount to its Net Asset Value. This is explained by the fact that the market price is determined by supply and demand. When the fund is initially offered to investors, the demand is high and therefore, the market price is at a premium to the Net Asset Value. This is how fund managers make money in offering the fund. However, over the long-term, the market price declines and remains at a discount to the Net Asset Value. This happens because small investors typically buy closed-end funds because they are low priced, but then they sell because they do not feel confident enough in regards to the funds' prospects.

Over three quarters of the closed-end funds invest in bonds, including government bonds, mortgage bonds, high-yield bonds and global bonds, while the remainder one-quarter are equity funds. There are closed-end funds that invest in specialized sectors such as utilities, health, precious metals, global equity markets, convertible securities, and municipal securities. One of the major attractive features of closed-end funds is that they offer diversification into particular foreign markets. For instance, emerging markets are risky and therefore, for the majority of investors, unattractive. However, if a closed-end fund focuses on an emerging market, small investors, who perhaps lack the knowledge of how to invest in such markets, have the major advantage of a professionally managed fund in such a volatile market along with the major advantage of diversification.

Sources:
http://thismatter.com/money/mutual-funds/mutual-funds.htm#tq9