Advantages and disadvantages of closed-end funds

Parksville Qualicum Beach business columnist speaks out about investments

Here’s another investment you can’t buy at your local financial corner store: the closed-end fund. It shares many characteristics with its wider-known cousin (the open-ended mutual fund), but with some differences:

Once a closed-end fund has been issued and starts trading on the secondary market you can no longer purchase it through the issuing company. Instead you must find another investor who is willing to sell. And while a healthy secondary market does exist for most closed-end funds, the market is not highly liquid. Often they will trade at prices below their net asset values (NAV).

This is not always a good thing for those who subscribe to initial offerings of closed-end funds. But for patient investors who wait and buy through the secondary market, one person’s loss can be another’s gain.

Closed-end funds can be particularly appealing for income oriented investors, since a lower purchase price means a higher yield. Plus an added bonus: some of them still benefit from income re-characterization: a significant tax advantage that our government has been trying to do away with through recent budget measures. In some cases they have been grandfathered for extended periods.

Some other distinguishing characteristics:

Less cash required. Since closed-end funds do not allow for daily redemptions at the whims of investors, managers do not need to maintain high cash values.

Investment Cash Flows. Successful mutual funds attract new money, as investors have a tendency to chase returns. Often the most successful fund managers find it difficult to continue to do well as they are inundated with cash from new investors. Closed-end funds don’t have this problem, since new investors do not add money to the fund. They simply buy existing units from investors who choose to sell. In fact with closed-end funds success can have the opposite effect, as the funds become more sought after.

No deferred sales charges (DSC). Traditional mutual funds are popular with advisors since they can be sold on a DSC basis, whereby the fund company pays a commission to the advisory firm up front. To recoup the upfront cost, the fund company will penalize investors for early redemptions. Since issuers of closed-end funds are not involved in secondary market trades, there is no need for deferred sales charges.

Jim Grant, CFP, CIM (Chartered Investment Manager) is a financial advisor with Raymond James Ltd (RJL). The views of the author do not necessarily reflect those of RJL. This article is for information only. E-mail: jim.grant@raymondjames.ca

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