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What You Should Know About Closed-End Mutual Funds

A closed-end mutual fund, legally called a closed-end company is often confused with an open-end mutual fund.  While closed-end and open-end mutual funds share some similar characteristics, they are very different in other important ways which every investor should know about before investing. Both are considered an Investment Company and must register with the U.S. Securities and Exchange Commission.

Here are five unique characteristics of a closed-end mutual fund:

Limited number of shares: A closed-end fund offers a limited number of shares to the public through an initial public offering (IPO) or subsequent public offering and then is closed to new investors.  Afterwards, these shares trade on the stock exchange or over-the-counter (secondary market) like a stock. 

Leverage: Over 70 percent of closed-end funds use leverage, borrowing against the fund’s assets, which increases risk exposure.  The fund is managed by an individual or team of professionals based upon the fund’s investment objectives and policies outlined in the prospectus and statement of additional information.

Price fluctuation: The market price of a closed-end fund share fluctuates and is subject to stock market risk, which is the risk that prices will decline adversely affecting the value of the closed-end fund.  Shares of closed-end fund frequently trade at a discount to NAV. Discounts may be attributable to many factors, including fund manager’s ability, past performance, and expectation of investors, among other factors.  Past performance is no indication of future results. 

Activist arbitrage: Fund companies can be pressured or elect to open-end a closed-end mutual fund selling at a discount to NAV.  If the fund becomes open-ended, the discounted share price must increase to the fund’s NAV.  Arbitrageurs take positions in a targeted closed-end fund selling at a discount and then lobby for a proxy vote to open-end the fund to profit from this phenomenon.  A research report titled “Activist arbitrage: A study of open-ending attempts of closed-end funds,” published in the Journal of Financial Economics, indicates that the larger the discount to NAV of a closed-end fund the greater likelihood of an activist arbitrage attack. 

Facts: By the end of 2009, there were 627 closed-end funds, including 419 bond funds and 208 equity funds, according to the 2010 Investment Company Fact Book.  One in three of these funds are U.S. municipal bond funds. Other closed-end funds include U.S. equity, international equity, U.S. taxable bond, and international bond.  Closed-end funds assets have decreased 27 percent to $228 billion at year-end 2009 down from the high of $313 billion at year-end 2007.  Closed-end mutual funds are not suitable for everyone. Before investing, review the prospectus to learn about the investment objectives, risks, expenses and fees. 

Personal finance expert for women, Christine Parker, CFP® is president of Parker Financial, LLC, a registered investment advisory firm in the state of Maryland.  The information contained herein should not be viewed as Parker Financial, LLC providing investment, tax or legal advice.  Before implementing any strategy, please consult your accountant, legal counsel and financial planner.  For more information, call toll-free 866-681.PLAN (7526) or visit http://www.pfadvisers.com (1/27/11.)

Resources:

Activist arb

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