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Closed-end funds (also called closed-end mutual funds) are an interesting variety of mutual fund.
Like normal mutual funds, closed-end funds pool investor money and put it under the control of a portoflio manager who then invests that money. What exactly the fund manger can invest in depends on the fund's charter. Some funds invest in stocks, others in bonds, and some in very specific things like tax-free bonds issued by the state of Florida in the USA.
The two things that distinguish a closed-end fund from an ordinary mutual fund are that (1) it's closed to new capital after it begins operating, and (2) its shares trade on stock exchanges rather than being redeemed directly by the fund.
That is, a closed-end fund will have an initial public offering of its shares at which it will, say, sell 10 million shares for $10 each. That will raise $100 million for the fund manager to invest. At that point, however, the fund's 10 million shares will begin to trade on a secondary market, typically the NYSE for American closed-end funds. Any investor who wishes to buy are sell fund shares at that point will have to do so on the secondary market. Closed-end funds do not redeem their own shares. Nor, typically, do they sell more shares after the IPO.
The fact that closed-end fund shares trade on stock exchanges leads to some very interesting pricing behavior. In particular, fund shares often trade at what look to be really irrational prices because secondary market prices are often very much out of line with underlying portfolio values.
For instance, US closed-end stock funds have share prices are typically about 10% less than per-share portfolio values. That is, if a fund has 10 million shares outstanding and if its portfolio is worth $200 million, then each shares should be worth $20 and you would expect that the market price of the fund's shares on the secondary market would be around $20. But, very oddly, that's typically not the case. The shares may trade for only $18 or even only $20. In the former case, the fund would be said to be "trading at a 10% discount to Net Asset Value," where Net Asset Value (NAV) is simply the fund's total assets minues total liabilities. In the later case, the fund would be said to be trading at a 20% discount to NAV.
Even stranger, funds very often trade at substantial premiums to NAV. Some of these premia are extreme, with premia of several hundred percent having been seen on occasion. Why anyone would pay $30 per share for a fund whose portfolio value per share is only $10 is not well understood, although irrational exhuberance has been mentioned.
The presence of discounts is also puzzling since if a fund is trading at a discount, you would presume that a rich investor would come along and buy up all the fund's shares at a discount in order to gain control of the portfolio and liquidate it at its (higher) market value.
A great deal of academic ink has been spent trying to explain why closed-end fund share prices aren't forced by arbitraguers to be equal to underlying portfolio values. Though there are many strong opinions, the jury is still out.
For more on closed-end funds, see www.closed-endfunds.com, www.ici.org, and the Security and Exchange Commission website at www.sec.gov.
--Sean Flynn, Professor of Economics, Vassar College
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