Why Investors Should Know About Closed-End Funds

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By Mark Jewell, AP Personal Finance Writer

BOSTON (AP) — Despite their exclusive-sounding name, closed-end funds don't maintain the equivalent of a velvet rope restricting access to VIPs.

The reality is that investors in closed-end funds tend to be wealthier than the average client in conventional open-end mutual funds, which far outnumber closed-end funds.

Yet it's not a matter of cost that gives closed-end funds their more exclusive reputation. It's the difference in how closed-end funds operate that introduces an extra layer of potential risk, and draws a different pool of investors.

With closed-end funds, managers sell a fixed number of shares when the fund launches in an initial public offering, and typically don't issue more if new investors want in. Through a broker, new clients must buy from an existing shareholder willing to sell.

Compare that to regular mutual funds, where the fund company continuously lets investors buy or sell their stakes. Managers balance the fund's cash flow through buying and selling stocks or bonds, so the fund expands or contracts as needed.

"Closed-end funds tend to draw the more savvy investor, and that's probably how it should be," says Tom Roseen, a fund analyst with Lipper Inc. "The investor who does well with them is someone who really pays attention."

That means understanding that demand for a closed-end fund's fixed number of shares will shift. It's reflected in the discount new investors can get when a fund's shares are trading below the current market value of the stocks or bonds the fund holds. But if the secondary market favors sellers, buyers may have to pay a premium above the fund's net asset value.

This difference can add up to magnified gains or losses. That's because the discount or premium adds another variable influencing returns, beyond how much the fund's assets may appreciate, and the expenses you pay to invest.

It doesn't always work out so well, but the math looked good last year. Closed-end funds gained an average 53%, outpacing open funds' 28.5% return, according to Morningstar.

The flip side? In 2008, closed-end funds fell an average 32.3%, slightly worse than the 29.9% drop for open funds.

Despite their potentially bigger returns, closed-end funds aren't as well-known as regular mutual funds, and they're not for everybody. Here are answers to a few key questions:

Q: How many closed-end funds are there?

A: U.S. investors can choose from nearly 630, which hold a total $228 billion. That compares with about 7,700 open-end funds, with $11 trillion.

With regular mutual funds, about twice as many primarily hold stocks rather than bonds. It's the reverse with closed-end funds: About twice as many focus on bonds than stocks. That's in part because nearly 40% of closed-end funds specialize in municipal bonds.

Munis' tax benefits hold special appeal for wealthier investors paying the highest tax rates — one reason why closed-end funds are popular with rich people.

Q: Do closed- and open-end funds invest in the same kinds of securities?

A: Yes and no. Both types of funds can hold stocks or bonds. But regulations give closed-end funds more freedom to invest in illiquid securities that can't easily be sold quickly and converted to cash. One example includes bundles of bank loans. While not all do, closed-end funds can use leverage, meaning they can borrow to buy securities when the fund manager believes the investment gains will offset borrowing costs. That can increase a closed-end fund's volatility.

Q: How do costs compare?

A: Investors in both closed- and open-end funds can incur varying sales charges, as well receive taxable capital gains distributions. Because most closed-end funds are small, they often don't operate as efficiently as open-end funds, which can charge lower expenses as they grow in size.

Q: How much is the typical discount or premium to buy into a closed-end fund?

A: Over the past 10 years, the average discount for closed-end funds has been 4.4%, according to Morningstar. That means investors can buy a share for 4.4% less than value of the underlying securities the fund holds. The current discount is around 3%. The highest discount — a reflection of the fear in a sharply falling market — was in November 2008, when it reached 15.5%. Over the past decade, the highest premium occurred in March 2004, at 0.3%.

If you're savvy enough to buy at a discount and sell at a premium — something few consistently get right — your return will include the difference between the purchase and sale prices, as well as any appreciation in the fund's holdings.

Q: Because most closed-end funds are trading at a discount, is now a good time to buy?

A: You'd be making a speculative bet, just as with any investment. The funds generally trade at a discount. Roseen, the Lipper analyst, says a premium might be justified if you're so confident in the fund's manager that it's worth paying extra to get in. Or, a closed-end fund might invest in a market niche that's so narrow there are few similar investing options at open-end funds or exchange-traded funds.

Jeff Margolin, a closed-end fund analyst with FirstTrust Advisors, says there are still good bets for investors.

"You need to pick your spots more carefully, because discounts have narrowed," Margolin says. "And you've got to lower expectations, because last year was kind of an anomaly."

Q: Where can I find information on closed-end funds, and current discounts and premiums for individual funds?

A: The industry's Closed End Fund Association has a wealth of data here. Morningstar also is beefing up its closed-end coverage, with information on its site. Morningstar recently purchased a closed-end fund data firm, Fundamental Data Ltd., which has information here.

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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