Our Recommended Broker

Get $50 in free trades.
Questrade Democratic Pricing - 1 cent per share, $4.95 min / $9.95 max FAQs
Learning Topics
Contact Us
FAQ Archive

What is a closed-end fund?

Closed-end funds are investment funds made up of an established pool of assets with a fixed number of units. Closed-end funds trade publicly on stock exchanges and in the over-the-counter market.

The number of shares or units in closed-end funds remains fixed, except in rare cases of an additional share offering, share dividend, or share buyback. Funds that have the flexibility to buy back their outstanding shares periodically are known as interval funds or closed-end discretionary funds. They are popular in the United States. In Canada, closed-end funds may also be structured with buyback or termination provisions. The prices of closed-end funds are based on market demand, as well as underlying asset value. Closed-end funds can trade at a discount, at par, or at a premium relative to the combined net asset value of their underlying holdings. Most trade at a discount. An increase or decrease in the discount can indicate market sentiment. The greater the relative discount, all other things being equal, the more attractively priced the fund. However, it is important to find out whether the discount at which a fund is trading is below historical norms. A widening discount could indicate underlying problems in the fund, such as disappointing results from an investment strategy, a change in managers, poor performance by the existing managers, increased management fees or expenses, or extraordinary costs such as a lawsuit. One way to achieve superior returns is to find a closed-end investment company that is trading at a discount and is about to be converted to an open-end fund. Conversion to open-end status, also known as a mutualization, eliminates the discount, because the fund will be bought and sold at net asset value. An investor who bought the closed-end fund at a discount would earn a capital gain by redeeming the investment after it was converted to an open-end status. In contrast, open-end mutual funds trade at a price equal to their net asset value. Net asset value is calculated as the sum of the fund’s assets, minus its liabilities, divided by the number of units issued and outstanding. Net asset value is commonly expressed in terms of dollars per unit. Closed-end funds offer certain opportunities for investment returns not available to investors in more traditional open-end investment, such as short selling and leveraging. Closed-end funds can provide a boost to unit holders’ total returns, especially in a bull market. For instance, in addition to capital appreciation of the underlying assets, the trading discount to net asset value may shrink or the fund may trade at a premium. In working with a closed-end structure, money managers have the flexibility to concentrate on long-term investment strategies without the need to reserve liquid assets to cover redemptions. Since the number of units of a closed-end fund is generally fixed, and capital gains, dividends, and interest distributions are paid directly to investors rather than reinvested in additional units, the investor’s task of tracking the adjusted cost base of funds is easier than for open-end mutual funds, where each distribution affects the cost base. Moreover, because of the fixed number of units to be administered, investors in closed-end funds may benefit from lower management-expense ratios (MERs) than open-end funds with similar objectives. Closed-end funds are subject to the reporting requirements of the stock exchanges on which they trade. However, because they have a smaller following than conventional open-end mutual funds, much less information is available on comparative performance. This lack of information on closed-end funds may mean that investors can take advantage of price anomalies. On the other hand, regulators, the media, and the public do not scrutinize closed-end managers as carefully as they do the managers of more popular types of investment funds. Like a stock and unlike an open-end fund, there is no assurance that closed-end funds will trade at net asset value. Hence, in bear markets, closed-end unit holders may suffer from capital depreciation of the underlying assets, as well as a widening of the discount to net asset value. Furthermore, since closed-end funds are not widely followed in Canada, they may trade for extended periods at prices that do not reflect their real value. Partly because trading prices may diverge from net asset value, closed-end funds are less liquid than open-end funds. Buyers and sellers must be found in the open market. The fund itself, with the exception of secondary offerings, which occur infrequently if at all, does not issue or redeem units. Commissions are paid at the time of purchase and at the time of sale. Although some open-end funds can be purchased directly from the issuer to save on commissions, this is not normally possible with closed-end funds. Unlike the deferred sales charge option available for many open-end funds, there is no schedule of declining redemption fees. On the contrary, if closed-end shares appreciate, the commission payable on sale could well be higher that it was at the time of purchase. Since many closed-end funds do not provide for automatic reinvestment of distributions (a feature of most open-end funds), the unit holder is responsible for reinvesting the cash that may build up in his or her account. This is not usually a problem, however, because many discount brokers help with dividend reinvestment. For closed-end funds that trade on foreign exchanges, any dividends are considered foreign income and are ineligible for the federal dividend tax credit.