Every so often when they’ve been presented with a large number of recent regulatory or disciplinary cases involving a specific type of investment, the financial industry watchdog, FINRA, will issue an “Investor Alert” that serves to heighten awareness among investors. Well, the other day, FINRA came out with a new alert about something called “closed-end funds.” Like with alt mutual funds, which FINRA has also issued a recent alert about, the presence of the word “fund” in “closed-end funds” seems to throw novice investors for a loop: they tend to immediately think of that old investment standby, mutual funds. And while traditional mutual funds and closed-end funds do have a lot in common, the differences are what’s crucial here.
What’s a “closed-end fund”?
According to the FINRA notice, a closed-end fund is “a type of investment company that pools money from investors to buy securities. Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments (including illiquid securities). Unlike mutual funds, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange.” Hence the term “closed-end.”
Another major difference between traditional mutual funds and closed-end mutual funds is that the latter pay off in distributions rather than returns. Difficulty distinguishing between the two has apparently been wreaking havoc on investors, who hear/read 6% distribution and want to jump in.
Here below, we’ve put together a few key characteristics of closed-end funds based on FINRA’s alert that you need to know before you purchase shares in one:
Like traditional mutual funds, closed-end funds charge annual fees and expenses.
Both mutual funds and closed-end funds use leverage which can magnify gains and losses.
Closed-end funds can hold a greater percentage of illiquid investments in their portfolios than can mutual funds.
In certain cases, the distributions of a closed-end fund can include a return of principal. That means the monies may come from the fund’s assets. Which means that there can be significant risk involved.
For more information, including the six questions FINRA suggested you ask before investing in a closed-end fund, click here to view their Investor Alert.
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