Closed-end option

NEW YORK – Closed-end funds have the misfortune to carry a name that connotes exclusivity, certainly not the more egalitarian overtones of a term like mutual fund. But closed-end funds aren’t the province of Wall Street insiders and can be as much an everyman investment tool as mutual funds.

Closed-end funds are like mutual funds in that they invest in securities such as bonds and stocks to give investors an easy way to help diversify their holdings. Both have managers who oversee and make changes to the holdings and both charge fees.

The term closed-end fund refers to the way these structures are created. Money is raised in an initial public offering and then the fund is essentially capped. That pool of money is invested and people are free to buy and sell shares of closed-end funds as easily and frequently as they would stocks. In a mutual fund, new shares are continually being issued as new investors come along.

Moreover, unlike a mutual fund, the sales of shares in a closed-end fund don’t affect the fund’s assets. Therefore, the fund manager doesn’t have to worry investors will pull their money from the fund and can perhaps more easily execute a long-term investment strategy.

While closed-end funds aren’t suitable for everyone, savvy investors with a tolerance for volatility can perhaps profit by taking advantage of the lower profile that closed-end funds tend to have – generally, closed-end funds are geared toward investors seeking income, not big institutions looking for capital appreciation.

“The big sharks are not swimming with you,” said Alexander Reiss, a closed-end fund analyst at Ryan Beck & Co. He contends the limited presence of big investment houses can make it easier for a diligent investor to compete in this arena.

Another important difference is that closed-end funds almost always trade above or below the value of the assets that make up the fund. This is referred to as the premium or discount. The share price of mutual funds, however, simply reflects the value of the fund’s holdings. Shifts in premiums or discounts do make some investors nervous.

As closed-end funds often change hands at a discount to their net asset value, there is sometimes money to be made. This discount often reflects overall investor sentiment but also the types of risks taken on by closed-end funds, which frequently invest borrowed money to enhance returns. One of the risks in using a leverage strategy, however, is that interest rates can change and eat into a fund’s returns.

In the second quarter, many highly leveraged funds fared poorly as interest rates rose. “Those funds that had a lot of leverage in them, they basically tanked,” said Tom Roseen, an analyst at Lipper Inc., which tracks funds.

“Though we had an absolutely dismal quarter for closed-end funds in the second quarter, the third quarter was great,” he said.

Roseen questions, however, whether closed-end funds have much room left to run and said those considering investing in them should look for funds trading at a discount to net asset value.