FIRE Finance: Closed End Mutual Funds - Should We Stay Away From Them?

Closed End Mutual Funds - Should We Stay Away From Them?

Edit Post Tuesday, June 16, 2009

[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]

Closed End Mutual Funds - Should We Stay Away From Them?

June 17, 2009: Most references to mutual funds in articles, posts and talks are meant for conventional or open-ended mutual funds. Closed-end funds are seldom talked about. Both are investment entities that invest collective assets of investors and trade securities according to a specific strategy. However there are significant differences between the two.

In an open-end fund, shares are created or destroyed at end of each business day as an investor invests in the fund or withdraws from it. Number of outstanding shares is the total shares owned by investors of the open-end fund. Thus both the number and value of shares vary each day due to changes in number of investors and value of securities. Merits of such a fund include liquidity, convenience, safety and ease of trading.

On the contrary the number of shares issued by a closed-end fund at an IPO (initial public offering) remains fixed thereafter. Here is the big one. The fund company is not responsible for redeeming shares. In other words if I am an investor in a closed-end fund and decide to get out of it I have to sell my shares through a broker at the market price. Just like any stock trade. In the unfortunate event of non-existent buyers I would be stuck with my shares. This also implies that one may be able to buy or sell such shares at premium because the share price depends on market's perception of the fund's prospects (among other factors). On the other hand for an open-end fund, the fund company is bound to redeem my shares even if it necessitates the manager to liquidate securities to raise cash.

Are closed-end funds worth it?

In spite of the above characteristics, a closed-end fund is not to be ignored. Suppose a major crisis strikes the market and investors are fleeing away. Everyone wants to sell their investments and sit tight on hard cash.

What will happen to an open-end fund in such a scenario?

The fund manager will be compelled to liquidate all its securities to generate cash for satisfying the redemptions.

But a closed-end fund's manager does not need to do so - he/she is in complete control. Case in hand - devaluation of Mexican Peso in 1994. Thus, single country closed-end funds or those focusing on a specific region may be worth considering. More so if they can be purchased at a discount.

Finally a word of caution. Closed end funds are better for savvy investors. One has to keep an eye for such funds being sold at a bargain to make a good buy.

Do you invest in any closed-end funds? If yes, which ones? Please feel free to share your experiences and expertise.

Image Source(s): iStockPhoto

Anonymous said...

Your article made me think of Berkshire Hathaway. Although, strictly speaking, it is not a closed-end fund, it acts very much like one. If the stock market declines, investor can't present their shares to Mr. Buffet for redemption (although I imagine he'd gladly purchase them). In addition, unlike traditional open-ended funds, Berkshire can invest in privately held companies, which gives Mr. Buffet a lot more options than a fund manager. Anyway, good post, and no, I don't own Berkshire shares.

I believe we should stay away from Closed End Mutual Funds since they are not very reliable.

FIRE Finance said...

Hi Dough Roller,
Thank you for sharing your thoughts. We own shares of Berkshire Hathaway in our Sharebuilder account. It has done very well over the years for us. We don't think we would sell them anytime soon, not a chance!

Hi Allen,
We are not sure where you are coming from. In our humble opinion closed end funds are as reliable as open ended ones. Consider this.

Domestic mutual funds have given an annual return of 13.3 percent for the 3 yr period ending last May 30. For the same period closed-end funds have returned 17.03 percent annually - 3.73% more!

Besides, as mentioned in the post, if we are fortunate, they can be purchased at deep discounts when the market is down. That is never possible for a open ended mutual fund.

All the basic caution that we practice while purchasing an open ended fund should also be applied to a closed end fund - solid track record, good manager, low expenses, aligned with our asset allocation strategy etc.

Good read! I own several closed-end funds which in structure are similar to an ETF. I like them because they are more tax efficient - capital gains are rarely generated since there are no redemptions.

Best Wishes,
D4L

@D4L,

Thanks a lot for your feedback. Indeed you are very correct about tax efficiency and ETF like behavior of closed end funds. Since you own closed end funds already here is something to reflect upon.

The economic outlook is bleak and market is not bullish by any standards. Our personal stand is bearish for foreseeable future. The occasional up ticks are due to opportunistic long-term aka buy-and-hold investors. If the major indexes take another beating we shall see panicky investors fleeing from stocks and eventually from funds as well.

Under such circumstances what would happen to an open-ended fund versus a closed ended one? Of course the open fund manager might have to sell it's underlying securities in order to redeem shares leading to more devaluation of the securities. But for a closed end fund there will be no such thing. Only transfer of fund shares from sellers to buyers (if any). At least the constituent securities of the fund don't bear the brunt directly. Perhaps it is a good thing for the market.

We wish you all the best with your investing.

Cheers,
FIRE Finance

Daddy Paul said...

I am a big fan of investing in closed end funds!

Closed End Mutual Funds - Should We Stay Away From Them?

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