Description

This article is from the A Guide to Closed-End Funds (CEFs).

Stability of the pool of investment money.

As discussed earlier, the pool of money available for investment remains stable for CEFs, but constantly fluctuates for mutual funds depending on the issuance and redemption of shares.

Protection of Investment Decisions.

The open-end structure of mutual funds poses problems for the investment manager during periods of wild sentiment swings. At market tops, individual investors tend to pour money into funds, leaving the fund manager with the unpalatable choice of increasing cash positions or buying stocks at rich valuations. Similarly, at market bottoms, individual investors tend to pull money from the funds, forcing the manager to sell stocks at low prices or to commit a larger portion of funds to cash as a cushion against such redemption. Clearly, the open-end structure of mutual funds tends to push managers into bad decisions: buy at highs, sell at lows, or stay uninvested. In closed-end funds, the investment manager can make investment decisions uninfluenced by such foolish behavior of individual investors: the pool of money available for investment remains steady, though the discount may widen.

Increased Investment Opportunities.

The closed-end format facilitates investments in illiquid and sometimes risky securities or markets. Often, many of the most profitable investments tend to be when a company is at its very early stage of growth, coming out of bankruptcy re-organization, or in emerging markets in developing countries. However, such investments tend to be highly illiquid. Mutual funds tend to invest in such instruments or markets sparingly, since there is a danger that investors will panic during adverse market conditions and, through redemptions, force the sale of assets at temporarily depressed prices. Closed-end funds, however, since they do not have to worry about such redemptions, can make illiquid investments, and many do. Some invest in private placements (e.g., H&Q Healthcare), some invest in extremely small companies (e.g., Royce OTC MicroCap), some invest in thinly traded markets (e.g., Turkish Investment Fund, Portugal Fund), and some invest in highly volatile securities like warrants (e.g. European Warrant fund).

Fund Leverage.

When an investment advisor is particularly bullish, he may borrow additional funds to invest. The closed-end structure, with its stable pool of investment money, faciliates such leverage, and many CEFs do use leverage when appropriate. Mutual funds have a much harder time borrowing funds and leveraging since their capital pool may change rapidly and dramatically.

 

Continue to:

• prev: Major Differences between CEFs and Mutual Funds
• Index
• next: Control over price of the funds' shares

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