Co-authored by Adam Joines.

The Financial Industry Regulatory Authority issued an investor alert regarding closed-end funds to explain what investors should know before investing. Like other mutual funds, closed-end funds are professionally managed portfolios of stocks, bonds and other investments. They can charge annual fees, utilize leverage to enhance returns, and invest in a diverse pool of assets to minimize exposure to unsystematic risk. Unlike open-end mutual funds, which issue new and redeem outstanding shares on a continuous basis, closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Buyers and sellers can trade these shares like stocks or bonds. The market price of a closed-end fund is therefore determined not only by its net asset value (NAV), but also the market price investors are willing to pay for fund shares.

The price of shares of a closed-end fund is based largely on distributions. Distributions derive from interest income, dividends, capital gains and occasionally a return of principal. Distribution amounts are calculated differently than open-end mutual fund yields. A yield shows income as a percentage of the fund’s current share price; closed-end fund distribution can vary with share price or a fund’s NAV, or be fixed by fund management prior to the IPO. Funds that return principal—especially those that do so because of previously fixed distribution rates—carry higher levels of risk because the fund must sometimes erode its asset base to generate income for distributions. Investors are encouraged to consider this and other factors before investing in closed-end funds, including personal investment objectives, the fund’s investment strategy, the percentage of IPO price actually invested, tax implications, how the distribution rate is set and whether shares are trading at a premium or discount to NAV. 

The FINRA alert may be accessed here.