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

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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

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