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Closed-End Funds: What You Need to Know

Closed-end fund distributions: where is the money coming from? © iStockphotocom/dem10

Closed-end funds are a type of pooled investment. They have become popular because some offer high distribution rates—as high as 6 percent or more. While closed-end funds might seem like mutual funds, the two products are different. And a closed-end fund's distribution rate is not the same thing as its return—even if the numbers might look similar. Here is what investors need to know.

What Are Closed-End Funds?

Like mutual funds, closed-end funds pool money from investors to buy securities and professionally manage portfolios of stocks, bonds or other investments. Both mutual funds and closed-end funds have an inherent net asset value (NAV) that reflects the value of the funds' underlying assets (less liabilities) divided by the number of shares outstanding. But, unlike mutual funds, closed-end funds trade like stocks, with a market price that fluctuates throughout the trading day. The market price may be higher or lower than the fund's NAV.

Investors in closed-end funds typically receive distributions on a monthly or quarterly basis. The funds may increase or decrease the distribution rate from one distribution period to the next. Depending on the fund's underlying holdings, distributions can include interest income, dividends, capital gains or a combination of these types of payments.

In some cases, distributions also include a return of principal (or return of capital). That means the monies used to pay the distribution come from the fund's assets rather than from any income generated by the investments in the fund's portfolio. This results in a portion of your investment being returned to you.

Distribution Rate, Total Return or Yield: What's the Difference?

Be sure not to confuse a closed-end fund's distribution rate with its total return. In general, a distribution rate is calculated by annualizing the most recent amount paid to investors and dividing the resulting amount by either the market price or the fund's NAV. The total return from a closed-end fund will take into account the change in share price from a specific point in time and the income the fund paid.

When looking at closed-end funds and traditional mutual funds, keep in mind that distribution rates and yields are different measures. A mutual fund's yield shows its interest and dividend income expressed as a percentage of the fund's current share price. However, with a closed-end fund, the distribution rate might also include a return of principal.

Six questions to ask before investing in a closed-end fund:

1. What is the closed-end fund's investment strategy? Read the fund's prospectus or the most recent annual or quarterly reports for details about the fund's investment strategies, risks, and other information. If the fund invests in bonds, look at how its net asset value has fluctuated as interest rates have changed over time. Be clear on whether the fund's strategy involves volatile or illiquid investments that may carry more risk. Remember that past performance does not indicate or guarantee future performance. You can obtain the prospectus and other company reports on the SEC's EDGAR database, the fund's website or through your broker.

2. How much of what I pay per share in a fund IPO will actually be invested? Typically, the initial public offering price of a closed-end fund may include a "built-in" sales charge of up to 5 percent of the price that goes to the broker who sells you the shares, plus an additional amount for the offering expenses. Read the fund's prospectus and talk to your broker to understand how much of the price you pay will actually be invested.

3. What are the tax implications? Like mutual funds, closed-end funds do not directly pay taxes but instead "pass through" tax obligations to investors. So you need to know how any closed-end fund distributions you receive will affect the taxes you owe. Remember that you have no control over the timing of the distributions you might receive, the sources that the closed-end fund will tap to pay them or the tax treatment that will apply.

4. How is the distribution rate set? To understand the fund's distribution policy, read its prospectus and prior distribution announcements to find out the source of money used to make distribution payments. Ask if the closed-end fund follows a managed distribution policy to pay a stated rate regardless of the fund's performance. If you see frequent returns of capital, ask why the fund is not generating enough income to fund distributions and consider whether you want to make an investment that returns your money along with any earnings. Also, keep in mind that a fund's current distribution rate is not indicative of the future distribution rates you can expect.

5. Are the shares trading at a premium or discount to NAV? Go to the fund's website or exchange where it is listed to determine how the price you are paying compares to the fund's inherent value. This is important because whether the fund's shares trade at a premium or a discount to NAV will affect your total return.

6. Does a closed-end fund fit into my investment objectives? If unclear, you may want to consult with an investment professional who understands these complex products, your investment objectives, time horizon and risk tolerance to see whether closed-end funds are right for you.

For more information on how to invest wisely, visit FINRA.org/Investors.

Gerri Walsh is Senior Vice President of Investor Education at the Financial Industry Regulatory Authority (FINRA).

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