Learn about closed end funds

Q: One of my colleagues was talking about a closed-end fund. What is this, and when might it be a good investment option?

Because the number of shares of a closed-end fund is fixed, an investor seeking to purchase or sell shares must pay whatever the market will bear. This situation is in sharp contrast to one involving a traditional mutual fund, where the market forces are on the fund's holdings, not on the mutual fund itself.

With closed-end funds, however, there is a second value: the actual price the market will bear to purchase the closed-end fund. Remember, you are not purchasing and selling a closed-end fund from a mutual fund company; you are trading on an exchange or over the counter. So, although logic would dictate that if the per-share NAV were $20, then the price per share also should be $20, oftentimes that is not the case.

When a closed-end fund is selling for $19 and the per share NAV is $20, the closed-end fund is selling for a "discount" of five percent. When a closed-end fund is selling for $21 and the per share NAV is $20, the closed-end fund is selling for a "premium" of five percent. Discounts and premiums are quite common based on the popularity of the funds underlying the investments.

Unfortunately, many investors chase closed-end funds and pay unnecessary premiums. They also sell closed-end funds, creating large discounts. All things being equal, an investor can profit handsomely by purchasing at a discount and selling at a premium, even if the per-share NAV never changes. An even better scenario is purchasing at a discount and then selling at a premium after the per-share NAV increases.

Because of the relatively lax reporting requirements (compared with traditional mutual funds), the market for closed-end funds is somewhat limited. This reality can present opportunities for the conscientious investor.

Send your money management questions to memoney@advanstar.com. Answers to our readers' questions were provided by Aaron Skloff, AIF, CFA, MBA. He is chief executive officer of Skloff Financial Group, a registered investment advisory firm based in Berkeley Heights, New Jersey. He may be contacted via http://www.skloff.com or (908) 464-3060. A more extensive version of this column appears online.