Today I want to talk about closed-end mutual funds. When a new investor stumbles across a closed-end fund, it’s common for the new investor to ask themselves, “what are CEF’s and how are they different from ETF’s?”. CEF’s, often phonetically pronounced as “Seth’s”, is an abreviation for closed-end mutual fund.
To understand CEF’s, you must first understand 3 key terms:
1️⃣ A Mutual Fund – Mutual funds are professionally managed investment funds that pool money from many investors to purchase securities. Mutual funds are actively managed and can be open-ended or closed-ended.
2️⃣ Actively Managed Mutual Funds – Both closed-end and open-end funds are run by investment advisors. The fund’s investment decisions are made by a fund manager or team of fund managers. When you invest in actively managed funds, “You’ll pay a flat fee regardless of whether your fund does well or does poorly ”🗣Investopedia. Professional fund managers do not work for free, the fees generated pay their salaries and for the funds marketing expenses.
3️⃣ Closed-ended Funds – Close-ended funds began trading publicly through an IPO just like stocks. Closed-end funds have a fixed number of shares, meaning that new shares can’t be created after the shares begin trading, this also means that managers cannot raise more money for the closed-end fund after the shares begin trading on the market.
Close-end funds are allowed to invest in unlisted securities, or securities that don’t trade on an exchange such as over-the-counter stocks and private companies. Open-ended funds are the opposite of closed-end funds and are represented by ETF’s and mutual funds; both represent different kinds of open-ended funds.
🤷♂️Should you buy a CEF or an ETF?
CEFs exist in a weird space between ETF and mutual funds, but typically aren’t a perfect substitute for either. Like mutual funds and ETF’s, CEF’s represent a pooled interest in a larger investment. When you invest in a CEF, you are purchasing a percentage of the closed-end funds larger investment. But, since CEF’s trade similarly to stocks and have a limited supply, sometimes the price of each individual share rises above the larger investments Net Asset Value.
When an individual investor trades on the stock market for more money than the asset that it represents, it puts investors in a precarious position where it is in their best interest to sell their shares (cash out), and could also scare off potential investors from investing until the trading price is more representative of the assets.
As mentioned above, closed-end funds have a fixed number of shares and begin trading publicly through an IPO just like stocks. When a CEF trades above the price of its underlying asset (NAV), it shifts the supply and demand dynamic, which could lead to depressed prices until the underlined assets rise in value or the CEF begins to trade at a discount.
Because ETFs have the same problem but CEF’s do not have the same liquidity advantages of ETFs, ETFs do a better job of keeping up with the price of the underlying assets (stocks) that are held within the ETF because new ETF shares can be created by its managers “out of thin air”.
I commonly refer to ETFs as a “big bucket of stocks”, and this is partly because ETF shares can be created almost simply by buying more stock and putting it into the bucket that holds all of its other stocks 🪣. ETFs also have the advantage of being more frequently traded than CEF’s, which adds to their liquidity.