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Closed-end Mutual Funds

A mutual fund that raises a fixed amount of capital from investors through an IPO

What are Closed-end Mutual Funds?

Closed-end mutual funds are mutual funds that raise a fixed amount of capital from investors through an initial public offering (IPO) and lists its shares on a stock exchange. A closed-end mutual fund is overseen by a fund manager, trades similarly to securities, and is considered a publicly traded investment company.

 

Closed-end Mutual Funds

 

Quick Summary:

  • Closed-end mutual funds are mutual funds that raise a fixed amount of capital and issues a fixed number of shares – additional shares cannot be issued, and existing shares cannot be bought back.
  • A closed-end mutual fund is considered a publicly traded investment company and must register with the relevant securities commission.
  • A closed-end mutual fund lists on a stock exchange, is affected by supply and demand, and can trade at a premium or discount to net asset value per share.

 

Understanding Closed-end Mutual Funds

In a closed-end mutual fund, an initial public offering is initiated to raise capital for the mutual fund. Shares are issued to those who contribute capital into the mutual fund. Afterward, the shares are listed on the secondary market and traded by investors based on supply and demand. A closed-end mutual fund, as the name implies, does not issue additional shares or buy back shares. The diagram below outlines the process relating to a closed-end mutual fund:

 

Closed-end Mutual Funds - How They Work

 

Key Characteristics of a Closed-end Mutual Fund

A closed-end mutual fund comes with the following key characteristics:

 

1. Management fees

It charges management fees.

 

2. Actively managed

It is actively managed by a fund manager.

 

3. Fixed capital and shares

It raises a fixed amount of capital and number of shares through an SPO.

 

4. Trades on an exchange

It trades on a secondary market (stock exchange).

 

5. No share issuance or redemption

It does not issue or redeem shares beyond the share issued in its IPO.

 

6. Changing share price

The share price of a closed-end mutual fund reflects the net asset value of the assets in the portfolio in addition to market supply and demand. A closed-end mutual fund can trade at a premium or discount to net asset value per share.

 

Share Price of a Closed-end Mutual Fund

A common area of confusion is how the shares of a closed-end mutual fund are priced in the market. The share price of a closed-end mutual fund changes based on the changing values of assets in the portfolio in addition to supply and demand and other fundamental factors. Supply and demand and other fundamental factors can cause a closed-end mutual fund to trade at a premium or discount to the net asset value per share.

Since a closed-end mutual fund is made up a fixed number of shares, high demand drives the share price while selling pressure depresses the share price. Demand and supply of a closed-end mutual fund can be driven by market sentiment, the reputation of the fund manager, poor return-and-risk profile, high management fees, etc.

 

Practical Example

Consider a closed-end mutual fund that raised $10 million in capital through an initial public offering. Following the IPO, the mutual fund issued 10 million shares for a NAV of $1 ($10 million / 10 million shares) per share. Assume for simplicity that the fund does not charge management fees.

 

A Premium NAV/share

A potential investor notices that the closed-end mutual fund is managed by a reputable Wall Street banker and is shareholder-friendly. The potential investor decides to purchase shares in the closed-end mutual fund. Noting that the current share price of $1, she offers a slight premium to the NAV per share to purchase shares from the current shareholders of the fund.

 

A Discount NAV/share

In the middle of a US-China trade war, an investor of the mutual fund notices that the mutual fund holds a large position in chip stocks. The investor believes that there will be soft demand for chips in China, and resultantly does not want to hold the mutual fund. He decides to sell his shares in the mutual fund at a discount to the NAV per share.

 

Pros and Cons of Closed-end Mutual Funds

Pros:

  • Mitigation of unsystematic risk due to the fund holding diversified securities
  • Managed by a portfolio manager with the help of analysts
  • Traded on stock exchanges, allowing for high liquidity

 

Cons:

  • Driven by supply and demand, which may cause the fund to trade at a discount
  • Charges management fees and expenses
  • Lacks a track record at the launch of the fund

 

Related Reading

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Investing: A Beginner’s Guide
  • Marketable Securities
  • Open-end Mutual Funds
  • Private vs Public Company

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