What is a Closed-End Equity?

Toni Henthorn
Toni Henthorn
Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

A closed-end equity fund is an actively managed, joint investment mutual fund through which a company raises a predetermined amount of money by issuing a limited number of shares to investors in an initial public offering. The shares, which represent equity in a specialized group of securities, trade on the leading stock exchanges. A closed-end equity fund is so named because the closed-end company issues a fixed number of shares only once, and unlike open-end funds, it will neither issue new shares nor redeem any shares. After the initial public offering, investors may only buy shares in the closed-end equity fund on the market or from other investors. Also unlike open-end funds, the price per share of a closed-end equity fund may fluctuate higher or lower, depending on supply and demand, than its net asset value (NAV), the value of the underlying securities in the fund.

When the price per share of a closed-end equity fund trades higher than its NAV, investors must pay more for the share than its underlying securities are worth, producing an immediate loss. In most cases, however, closed-end funds trade lower than the NAV, by as much as 25 percent. With the fund trading at a discount, an investor receives exceptional value for the price he pays per share. For example, imagine a closed-end issues 20 million shares at $10 U.S. Dollars (USD) each, bringing $200 million USD into the fund and investing it in stocks and bonds yielding about eight percent. After the release, the share price falls to $8.50 USD per share while the asset value stays at $10 USD, yielding dividends at 9.4 percent instead of just eight percent.

In general, it is advisable for investors to avoid purchasing closed-end equity fund shares during the initial public offering. The share price is likely to decline after all of the shares are purchased. In addition, investors should avoid purchasing closed-end funds that are trading at a premium. The goal should be to buy funds that are trading at a moderate discount. If the discount becomes too deep, the fund manager will take steps to either stimulate interest in the fund or repurchase shares in an attempt to reduce the disparity between the NAV and the share price.

In addition to the distinctions already listed, closed-end equity funds differ from traditional mutual funds in that the closed-end funds typically use leverage to improve their returns. This leverage provides a greater cash dividend for the investor. It also, however, increases the risks of the fund. For this reason, investors should be extremely wary of closed-end funds that have a debt to total asset ratio that exceeds 40 percent. Investors calculate the debt ratio by dividing the total debt by the total value of the fund assets.

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