Quora Answer: What are Closed End funds (CEFs) & How Should They Fit into Someone's Portfolio?

The following is my answer to a Quora question: “What are Closed End funds (CEFs) and how should they fit into someone’s portfolio?”

A closed-end fund (CEF) is a form of collective investment scheme, where the number of shares issued are fixed, and are not redeemable by the fund.  Redemption is through selling the shares.  In contrast to an open-end fund, new shares are not created to meet new demand and raise further capital.  Further capital is raised through leveraging, such as through preference stocks, debt instruments and buy-sell agreements.  Share may only be traded in the market.

CEF are usually listed on an exchange, and may be traded like any other counter.  The price is, thus, determined by market demand, not the net asset value (NAV) per share of the fund.  The price is described as at a discount or premium of the NAV.  This is determined by market confidence in the fund manager, and the positioning of the underlying assets relative to the economy.

CEFs have some financial advantages over OEFs.  For one, they are not subject to market fluctuation, and the pressures of maintaining their record.  Adverse market movement due to sentiment, and not underlying value, does not affect CEFs as much.  They are better placed to take advantage of this to go bargain hunting, for example.  Since they do not have the expense of creating or redeeming shares, they have no requirement to keep substantial cash on their portfolio, which reduces their currency exposure.

CEFs are also immune to the herd mentality of a market panic, where particular stocks or market segments are subject to mass selling.  An OEF may be forced to sell stocks they would rather keep in order to maintain liquidity for redemptions.  He may be forced to take a temporary position, with weightage and counters that are less than ideal to maintain liquidity.  This leaves OEF temporarily overweight, and might even contravene their mandate.  No such thing can happen on a CEF because you can only sell it to someone else, the secondary market, and this does not affect the overall holdings of the fund itself since only stocks are moved, not the underlying positions.  This may cause the CEF stock to be had at a discount, but this also means that it will rebound relatively quickly.

In a sense, a CEF may seem more volatile than an OEF.  It is meant for investors who are more sophisticated, with a higher risk tolerance.  CEF tend to outperform OEF and index funds in the short term.  CEF are a good addition to any serious investor who has done his homework on the fund, since they have the potential to generate good returns.  They are meant to be bought and held, not so much traded, since the good ones tend to pay out a decent yield on the dividends.