Many investors have a general understanding of mutual funds: An investment vehicle that lets investors combine their money into one pool in order to purchase a diversified collection of financial assets.
Yet, far fewer investors have an adequate understanding of ‘closed-end funds’. This is true despite the fact that these funds are becoming ever more popular.
Indeed, there are many investors who actually own closed-end funds (often at the recommendation of a financial advisor) who do not actually understand what they bought. This is troubling, as far too many investors are getting themselves into financial positions that are not truly in their best interests.
While closed-end funds are appropriate for some investors, these types of funds are highly complex and they come with some additional risks. Here, our team discusses some of the distinguishing features of closed-end funds, and we highlight how these funds can potentially result in major losses for investors.
Understanding Closed-End Funds
Four Key Features of a Closed-End Fund
- Fixed shares: Closed-end funds issue a specific number of shares through an initial public offering (IPO). Once those shares are issued, that is it.
- Active management: For the most part, closed-end funds are actively managed. Decisions made by the fund’s managers could dramatically alter the actual composition of the fund and the amount of risk that is taken on by the fund’s investors.
- Not directly redeemable: If you want to sell shares of a closed-end fund, you cannot redeem them directly from the issuing company. Instead, you must sell your shares on the open market at whatever the current price may be.
- Prices fluctuate: Closed-end funds trade on markets, similar to stocks. The price can change from minute to minute. Further, the price of the fund may not always be consistent with the value of the assets held by the fund.
Closed-End Funds vs. Mutual Funds
Like mutual funds, closed-end funds pool investor money to purchase financial assets (stocks, bonds, securities, etc). This is certainly useful, as it offers investors easier access to a ‘diversified’ portfolio. However, unlike mutual funds, closed-end funds cannot be redeemed directly from the issuing company.
The price for a mutual fund is determined once each day, and investors can get in (or out) of the fund at any time. With a closed-end fund, the fund trades on the market, like a stock, and the value (at any given moment) will be determined by supply and demand.
Closed-end Funds vs. Exchange Traded Funds (ETFs)
ETFs share some similarities with closed-end funds; most notably, that they are structured in a similar manner and trade on the open market. However, unlike closed-end funds, ETFs are almost always passively managed. For example, Vanguard’s S&P 500 ETF simply attempts to track the index as close as possible.
As ETFs are passively managed, their market price usually tracks extremely closely to the value of the underlying assets. With an ETF, you are not really investing in the ‘know-how’ or ‘skill’ of the fund managers. Instead, you are simply investing in the underlying assets that are held in the fund. This is in stark contrast to most closed-end funds, where the spot price for the fund may not be reflective of the underlying assets.
Investors Must Be Careful: Closed-End Funds Carry Heightened Risks
For many, closed-end funds are simply unsuitable investments. You should not be invested in these funds unless you have a full understanding of the advantages and risks. Further, your financial advisor must take proactive steps to ensure that any fund that you invest in is fully consistent with your overall investment objectives and desires. With closed-end funds, there are many causes for concern, including:
- Limited Transparency: Unlike ETFs, most closed-end funds offer very limited transparency. At any given time, fund investors may not really know the future strategies the fund managers will employ.
- Illiquidity: You can only sell a closed-end fund if you can find a buyer. Unfortunately, for many of these funds, there are just not that many reliable buyers out there.
- Highly leveraged: Many closed-end funds invest using leverage (debt) as a large part of the overall strategy. By nature, this makes these funds far more volatile.
- High fees: Finally, closed-end funds have management fees that are considerably higher than the fees that come with ETFs or other passive investments. These fees can quickly eat away at any investor gains.
Contact Our Investor Losses Lawyers Today
Have you sustained substantial losses investing in closed-end funds? If so, you may be entitled to recover compensation. To set up a free review of your claim, please contact our team today by calling 844-689-5754 or by emailing us directly through our website. At the Sonn Law Group, we represent wronged investors in the United States, Puerto Rico and internationally.