If you are an investor who is thinking of backing a closed-end fund, it is important that you understand what this type of fund is and what are its accompanying risks before you decide to invest. While closed-end funds have been known to pay off-their high distribution rate is one of the features that make these products so popular-the losses can be substantial especially if your portfolio can’t handle them.
Closed-End Funds: What Are They?
These funds are a kind of investment company that gets money from investors to purchase securities. Closed-end funds are like mutual funds in that they manage portfolios that include investments, such as stocks, bonds, and even illiquid securities. However, they differ from mutual funds in that in an initial IPO, closed-end funds will offer a set number of shares to be traded on the exchange.
The demand and supply of closed-end funds determines their price in the market. Closed-end funds possess an inherent net asset value that shows the value of the funds’ underlying assets divided by the quantity of outstanding shares. The funds’ market price may change during the day.
Investors are paid distributions by close-end funds on a quarterly or monthly basis and the amount may change between distribution periods. Distributions may include capital gains, interest income, dividends, or a combination of these payments, and perhaps even a return on principal. However, closed-end funds that provide this return may come with a higher risk level.
One reason for this is close-end funds raise their distributions via leverage-borrowed money-and this can increase risks especially if the part of the market invested in doesn’t do well. Other risks can occur if share prices can move far away from the value of the underlying securities of the fund or if the stream of income is not steady because certain closed-end funds are just giving investors back the money they put in.
A rise of short-term rates might also compel the fund to pay a higher rate on borrowings than what it made on investments. Another potential problem with closed-end funds is that share prices may fluctuate a lot from the net asset value. Furthermore, just because a closed-end fund did well one year doesn’t make this an indicator of how well it will do the following year-especially when the market fluctuates.
The Financial Industry Regulatory Authority says there are several elements to consider before an investor should decide to invest in a closed-end fund:
1) Does the fund meet your investment goals? Your investment professional should make sure you understand if this type of investment is compatible with your objectives.
2) Do you understand the funds’ investment strategy?
3) How much of what you pay per share in an IPO is actually invested? How much is of this is a sales charge?
4) Are there tax implications and how will this affect you?
5) How is the distribution rate established?
6) How are the shares trading-are they at a discount to NAV or at a premium?
At Shepherd Smith Edwards and Kantas, LTD LLP, our stockbroker fraud law firm represents investors that have suffered closed-end fund losses because their financial representatives recommended these investments to them even though the funds were unsuitable for their goals. We know how devastating it can be to lose your investment because of poor advice that you received from someone you entrusted to help you make the best choices. Contact one of our closed-end fund lawyers today.
Closed-End Funds, Securities and Exchange Commission
High Income, Added Risks, The Wall Street Journal, December 5, 2011
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