The specificity of closed-end funds is that they issue shares, not units like open-end investment funds in the short term. Investing in a closed-end investment fund is the same as buying shares of a company.
This is most often done through a public offering of shares, which means that whoever wants can “buy” the fund’s shares at a certain price in the planned period.
The amount of the fund’s assets (eg $20,000,000.00) and the price of one share (eg $1,000.00) are determined in advance.
It may happen that more or more shares are sold (professional name is: subscribed) and then the value of the fund will be calculated based on the paid-in shares.
If too little money is accidentally collected or too few shares are subscribed for the establishment of the fund, the money is returned.
After the expiration of the deadline and if sufficient funds have been collected, the fund is entered in the court register, and its shares can from then on be bought and sold through the stock exchange.
In other words, if you want to buy shares of a closed-end investment fund, someone else must offer them for sale and vice versa, and the purchase and sale itself takes place through the stock exchange as well as for shares of other companies.
The situation is completely different with open-end investment funds. You can buy new shares with them at any time because the fund will issue new shares and increase its assets by that much. Likewise, an open-end investment fund is OBLIGED to repurchase these shares from you at any time.
There is another big and interesting difference between open-end and closed-end funds. In open-end funds, the value of one unit is calculated by calculating the total assets of the fund (the value of all shares and bonds and other securities), then the assets are reduced by the fund’s fees and liabilities and divided by the number of issued units.
The price of one unit is directly related to the value of the fund’s assets. Units of open-end investment funds may not be sold at a price different from the calculated one.
For closed-end investment funds, the net asset value of the fund (NAV) is calculated in the same way as for open-end funds, provided that if they invest in real estate, the value of the real estate is determined by appraisal.
What about the stock price on the market (stock exchange)? It is not calculated but its price depends on the law of supply and demand, investor expectations, market conditions, etc.
With closed-end funds, often their asset value does not match the price of their share in the market. If the stock price in the market is lower than the asset price then we are talking about a discount, and if the stock price is higher than the asset value then it means that the stock is being traded at a premium.
Let’s say that a new closed-end investment fund is being established, which will mostly invest in real estate, and that the price of one of its shares has been set at $1,000.00. The fund plans to raise $20,000,000 and invites investors through a public offering.
The subscription of shares lasts for 15 days and let’s say that he managed to collect exactly $20,000,000.00, ie 20,000.00 shares were subscribed at a price of $1,000.00.
Then, for that money, the fund buys business premises and real estate in the value of $15,000,000.00 and divides the remaining $5,000,000 into shares, bonds, cash on the account, etc.
After one year, the assessment determined that business premises and real estate were worth $21,000,000.00, while other assets invested in shares, bonds and other assets increased from $5,000,000 to $6,000,000.
The total assets of the fund amount to $27,000,000. (21,000,000.00 + 6,000,000,00) If we ignore the costs and obligations of the fund, what should be the share price?
We still have 20,000 issued shares. We divide the assets of $27,000,000 by 20,000 shares and get the value of one share of $1,350. Net asset value of the fund per share is $1,350.00. We compare this value with the share price on the stock exchange.
If the price on the stock exchange is $1,200.00, it means that the share is traded at a discount, and if it is $1,400.00, it is traded at a premium.
Investment risks of Closed-end investment funds
It is difficult for me to give a simple answer whether closed-end funds are riskier or better than open-end funds or not. It depends on what and how they invest and who manages them. That’s exactly why you have to read the prospectus and statute of the fund.
Those closed-end funds that mostly invest in real estate also bear additional risks, since e.g. tax laws can affect the price of real estate, and attention should also be paid to which criteria / standards are used to assess the value of real estate in the fund. Although they are not as popular as open-end mutual funds, I think they can be interesting to invest in.