What are closed-end funds, and are they risky?

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The share count is zipped up like a freezer bag.

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Looking to invest in a fund that offers high yields and a chance for capital appreciation? You might like to consider closed-end mutual funds.

Closed-end funds share some similarities with open-end mutual funds, exchange-traded funds (ETFs), and unit investment trusts; however, there are some significant differences as well.

One of the hallmarks of closed-end funds is their ability to use leverage to get juicy yields. It’s an important consideration for anyone looking to invest in these funds.

Closed-end funds are registered under the Investment Company Act of 1940, along with open-end mutual funds, ETFs, and unit investment trusts. Similar to these other funds, closed-end funds hold professionally managed portfolios of stocks, bonds, or other securities. They are registered with the Securities and Exchange Commission and subject to SEC regulation.

They’re called “closed-end” because the issuer sells a fixed number of shares during an initial public offering (IPO)—unlike ETFs and mutual funds, which continuously offer shares to meet investor demand. After its IPO, a closed-end fund is usually listed on an exchange, such as the New York Stock Exchange, where it trades on a secondary market.

Unit investment trusts also make a one-time public offering of only a specific, fixed number of securities. A key difference between the two is that unit investment trusts have set expiration dates. When these funds terminate, the holdings are sold and proceeds are paid to investors.

Closed-end funds trade like stocks; the supply and demand for shares determines the fund’s price. But similar to unit investment trusts, mutual funds, and ETFs, a key metric for closed-end funds is their net asset value (NAV). The NAV reflects the value of the fund’s holdings, minus liabilities, divided by outstanding shares.

All these funds have a share price, but what makes closed-end funds different is that the share price can be much higher or lower than the fund’s NAV. A share price that trades higher than the NAV is known as a premium; a lower price is called a discount.

Share prices may trade at premiums or discounts for many reasons, including investor sentiment and market perceptions. According to FINRA, most closed-end funds have historically traded at a discount to NAV.

Share prices and NAV can typically be found on a given fund’s website and through the listing exchange’s data feed (which means you can also access fund data from most trading platforms). If you’re interested in buying a closed-end fund, look at the fund’s holdings, expense ratio, and strategy, plus:

The fund’s website will also provide the regulatory information you need to conduct your due diligence, including quarterly and annual reports, proxy statements, fact sheets, and prospectuses. The website should also have investor relations contact information in case you have questions.

If you’re looking for both share appreciation and income generation, look to see where a fund’s current share price is compared to its historical discount or premium. Buying a closed-end fund at a discount can be a good value, but it all depends on what the fund owns. When a closed-end fund deviates from its NAV, there’s usually a reason.

Closed-end funds pay distributions on a monthly or quarterly basis to investors. Many funds aim for a fixed distribution rate. This money can come from several sources:

The SEC requires a fund to send out a written disclosure, called a 19(a) notice, when a distribution includes a return of principal. Returning principal reduces the fund’s asset size, which can be considered risky because if a fund’s asset base is smaller, there’s less money available to generate income.

Remember: The distribution rate should not be confused with a total rate of return.

Closed-end funds have a similar tax treatment to mutual funds. They are considered “pass-through” vehicles, meaning that their holdings are actively managed and the taxes incurred are passed on to shareholders. Thus, they’re not as tax efficient as most ETFs, which assess taxes only when an investor closes their position and incurs a capital gain (or loss).

Closed-end funds can own a greater number of illiquid securities than mutual funds. This can influence the fund’s NAV and its premium or discount.

But typically, the bigger risk is closed-end funds’ potential use of leverage (i.e., borrowed money). That’s how they can offer yields of 7% or more. Regulations allow leverage of up to 33%.

Leverage allows closed-end funds to raise more money to purchase additional portfolio assets, which can help them achieve higher long-term returns. But leverage is a double-edged sword; it amplifies gains, but it can also amplify losses.

Leverage that’s used to increase portfolio assets is known as structural leverage. Managers may borrow, issue debt, and issue preferred shares; issuing preferred shares is the most common structural leverage action. But again, these secondary issuances are made outside the common share count, which was fixed at the time of the IPO.

Managers may also use portfolio leverage, which involves derivatives or other complex financial products. The Investment Company Institute says that as of the end of 2022, around 62% of closed-end funds used leverage. If you own a fund that uses leverage, pay close attention to the yield curve, especially if the Federal Reserve signals a change in monetary policy. Leverage becomes more expensive as rates rise, so closed-end funds that use leverage are in danger of losing money in a rising interest rate environment.

To recap, here are some of the basic differences between closed-end funds compared to mutual funds, ETFs, and unit investment trusts:

Closed-end funds can be a good option for investors who are seeking high yield, but as with any investment, you need to know what you’re buying. Read the prospectus closely along with other fund literature to make sure you understand the fund’s investment strategy, its fees, and whether it fits with your goals and risk tolerance.