Closed-end option

They’re only a sliver of the investing universe compared with traditional mutual funds, but closed-end funds can be an interesting alternative for investors looking for attractive yields or access to less-liquid markets. They may not be right for buy-and-hold investors, however, as some of the strategies they use, such as leverage, can pose significant risks.

On the surface, closed-end funds don’t seem too dissimilar to their open-end cousins; they are actively managed baskets of stocks and bonds, and their shares can be bought and sold by investors both large and small. There are some important differences, however, including the fact that most closed-end funds are priced intraday, like stocks and exchange-traded funds. This means investors incur commission fees when they buy and sell them.

In addition, as their name implies, closed-end funds typically have a fixed number of shares, first issued in an initial public offering and later traded on the exchange, where their price is determined by the market. In contrast, open-end funds sell new shares and redeem existing shares every day, which can cause wild fluctuations in asset levels. New shares of closed-end funds are sometimes issued in secondary offerings, but the funds are not under any obligation to do so. Depending on demand, shares of closed-end funds may trade below their net asset value, at a discount, or above the NAV, at a premium. For experienced investors, much of the profit in closed-end funds lies in buying at a discount.

According to the Investment Company Institute, at the end of 2005 there were 634 closed-end funds with combined assets of about $276.35 billion. The 201 ETFs on the market are more widely held, with combined assets of $312.79 billion. Traditional mutual funds, numbering more than 8,300, remain the most popular investment, with combined assets of about $9.193 trillion, according to ICI.

Despite the difference in asset levels, a recent survey found investors are more familiar with closed-end funds than they are with ETFs. The study, commissioned by Nuveen Investments, a major provider of both products, found that investors who buy closed-end funds like them because they can generate income and provide access to assets and strategies they might not get otherwise. Investors also appreciate their liquidity, said Anne Kritzmire, managing director at Nuveen Investments, which sponsors the Web site www.ETFconnect.com.

“If you’re looking for income, as retiring baby boomers are going to be, this is an important investment type to consider,” Kritzmire said. “These are not a substitute for anything, they are a complement. We think it’s an important part of the retirement income discussion.”

If you’re wondering how to work closed-end funds in with the rest of your holdings, it’s important to keep in mind that they tend to focus on specialized asset classes, said Christine Benz, director of fund analysis with Morningstar Inc. For this reason, they’re more likely suited to the edges of your portfolio than as core holdings.