What are “Close Ended Mutual Funds?

Close-ended mutual funds are a type of actively managed pooled investment vehicles (having an underlying portfolio of assets) that list on a stock exchange and raise a fixed amount of capital from investors via an initial public offering (IPO). They issue a fixed number of shares to those who contribute capital into the mutual fund. Following the raising of capital via an IPO, the shares of a close-ended mutual fund are listed on the secondary market of a stock exchange.

The shares are traded in the] market (just like stocks), based on demand and supply, and allow for high liquidity. A new investor purchases existing shares and no new investment money is accepted into the fund, and an investor in the fund who wants to dispose of his or her shares sells the same to other investors. Thus, the number of outstanding shares remains the same.

Key Learning Points

  • The net asset value (NAV) is the total value of a mutual fund’s assets minus the total value of its liabilities.
  • Close-ended mutual funds can trade at a premium or a discount to their net asset value (NAV)
  • There are several advantages and disadvantages of close-ended mutual funds

Close-Ended Funds, NAV, Discounts, and Premiums

The Net asset value (NAV) is defined as the total value of a mutual fund’s assets minus the value of its liabilities.

NAV = Value of a Fund’s Assets (VFA) – Total Value of its Liabilities (VOL)
VFA = Value of all the securities in the portfolio of a mutual fund
VOL = Value of all the liabilities and fund expenses of a mutual fund

The Net asset value is typically shown on a per-share basis. Its formula is stated below:

NAV per-share = (Value of a Fund’s Assets (VFA) – Total Value of its Liabilities (VOL))/ Total Number of Shares Outstanding

Close-ended mutual funds (unlike open-ended mutual funds) can trade at a premium or a discount to their NAV – depending on the demand for their shares and other factors such as overall market volatility, recent NAV and performance of its share price among other reasons. Close-ended funds trade at a premium (discount), when the share price is above (lower than) the NAV.

Close-ended funds usually trade at a discount to their NAV and have a fixed maturity period.

Close-Ended Funds – Advantages and Disadvantages

Close-ended funds are more suitable for long-term investors i.e., those with a long-term investment horizon. The lock-in period until maturity in such mutual funds ensures that investors who invest in the same make adequate capital gains on their investment. Further, these funds have an advantage in terms of a stable asset structure, which enables the fund manager to formulate an investment strategy more easily without having to worry about inflows and outflows. Moreover, the shares of close-ended mutual funds are available at market prices and these funds should provide regular cash flow to the investor.

However, compared to open-ended mutual funds, close-ended ones are less liquid. Further, investors have no provision for making regular investments in such funds through systematic investment plans (SIPs). Moreover, close-ended funds can be exposed to pricing, market, interest, credit, leverage and currency risks.

Close-Ended Funds, Discounts, and Premiums

Given below is an example to clarify the meaning of ‘discount’ and ‘premium’ to NAV.  Suppose there is a close-ended mutual fund whose share price, determined by the market, is $20 and its NAV per-share is $22. Based on this information, the ‘’Discount” is calculated as: (Share Price/NAV) -1.’ Using this formula, the share is trading at a discount of 9.1% to the NAV.

Next, if the share price, determined by the market, is $13 and the NAV per share is $11, then using this formula, the share is trading at a “Premium” of 18.2% to the NAV.

Close-Ended Funds, Discounts and Premiums - Example

Next, assume that a close-ended mutual fund’s underlying portfolio at NAV yields 10%. Further, assume that the shares of this fund trade at an Absolute Discount (= share price – NAV)/NAV) of 5% (calculated below).

Next, we assume that an investor is buying these shares at a discount. Now, since the investor is purchasing these shares at a discount, he or she will get a higher yield or “Yield Enhancement” = 1.05% (calculated below).

Yield Enhancement