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Closed-End Funds - Risks and Benefits

written by: Tim Plaehn•edited by: Rebecca Scudder•updated: 6/28/2011

Investors who wish a diversified portfolio and regular income with easy liquidity will find closed-end funds a beneficial addition to their list of investments, though with its own share of risks.

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    Before investing in closed-end funds, it is good to know the distinction between closed-end funds and open-end funds, also known as mutual funds. With open-end funds, the investor can buy shares at any time by purchasing them from the mutual fund company. Mutual funds create and redeem shares to meet investor demand

    A closed-end fund issues a pre-determined number of shares. Closed-end funds issue a fixed number of shares at the time of the initial public offering (IPO) which are then used for secondary trading in the securities exchange. Investors who want to buy or sell these shares have to trade in the secondary market. Closed-end funds are professionally managed and typically invested in equities, bonds or a combination of both.

    Closed end funds can be useful investments in the current market environment.

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    Features of Closed-end Funds

    • The portfolio of a closed end fund is managed by professionals to meet the fund's investment objectives.
    • A closed-end fund has management fees which are calculated as a percentage of Net Asset Value
    • Fund shareholders are eligible for periodic dividends if the fund portfolio earns dividends or interest.
    • The total number of shares is limited and issued through an initial public offering.
    • The shares are traded in the secondary market on the stock exchange.
    • They can trade at a discount or a premium to the NAV (Net Asset Value) depending on the demand of shares
    • The liquidity of a closed-end fund depends on the share volume traded per day.
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    Types of Closed-end Funds

    There are several types of Closed-end funds for the intending investor to choose from:

    • Municipal bond funds
    • Taxable U.S. bond funds
    • Diversified U.S. equity funds
    • International and global funds
    • Commodity and natural resource funds
    • Preferred funds
    • Convertible funds
    • High-yield funds
    • Real estate investment trust (REIT) funds

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    Benefits of Closed-end Funds

    • Funds are managed by professionals and market experts.
    • Closed end funds have wider latitude than mutual funds in the use of leverage, which can boost dividend yields and returns.
    • Easy liquidity as traded daily in the securities exchanges.
    • Low investment as per requirement.
    • Wide choice of losed-end funds currently available in the marke.
    • Buying and selling flexibility.
    • Possibility of getting higher yields on income than a number of other capital market funds.
    • With a fixed number of shares, closed-end funds can remain fully invested and invest in long term securities which may result in higher returns for the investors.
    • Closed end fund shares may be purchased at a discount to NAV, which can boost returns if the discount narrows or the share price moves to a premium.

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    Risks involved in Closed-end Funds

    • Share price in the secondary market can be volatile.
    • Leveraging can produce adverse effects and be interest-sensitive
    • Closed end fund shares trading at a discount may see the discount widen.
    • Each closed-end portfolio carries a different set of risks and therefore research is required before investing
    • Do not have redemption privileges or repurchase schemes that keep price in line with NAV.

    The risks of closed end funds is dependent on the individual portfolio of each fund, but fund share prices can also be affected by general stock market trends.