Pros & Cons of Closed-End Funds

Closed-end funds get the name because fund shares are sold one time with an initial public offering, and then the fund closes to the sale or redemption of shares. After the IPO, the shares of a closed-end fund trade on one of the stock exchanges. One way to view closed-end funds is that these funds are actively managed like most mutual funds and trade on the stock exchange like ETFs. As a result, closed-end funds are a hybrid of mutual and ETF fund features.

Both the rules governing closed-end funds and the fact that fund managers do not have to worry about investors redeeming shares means that investors can find closed-end funds covering very focused investment themes. There are single-country stock funds and single-state municipal bond funds. Closed-end funds cover some of the smaller sectors of the stock market and the more complicated sectors of the bond markets. Closed-end funds let investors go into investment types where no other type of security is available.

A large portion of the available closed-end funds can be classified as high-yield investments, paying quarterly or monthly dividends. The high-yield closed-end funds include taxable bond funds, municipal bond funds, domestic stock funds and foreign stock funds. An investor who needs or wants a high level of income from her investment portfolio has hundreds of funds to choose from off the closed-end fund list. Many closed-end funds strive to maintain a steady dividend rate.

To invest in closed-end funds you get hit with a double whammy of expenses. To buy or sell shares, you will pay commissions to your broker. Also, the management expenses of closed-end funds are typically much higher than with ETFs, index mutual funds or even the average actively managed mutual fund. Take a look at what a closed-end fund charges before making an investment, and make sure the investment potential provides some justification for the higher expenses.

It can take some digging to figure out what a specific closed-end fund invests in and how it generates the big dividend that attracted you in the first place. The dividends paid by a fund could be from interest, dividends, capital gains or even return of your own capital, so you need to analyze where the payout comes from. The market price of a closed-end fund can be higher or lower than the funds net asset value -- NAV -- and another analysis is what is the average share price premium or discount and what could make it change.