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Municipal Bond Funds: Advantages of Closed-end versus Open-ended funds?

What are the advantages of using Closed-end mutual funds for tax-free income, versus the open-ended offerings?

Nov 26, 2012 by Chris from Greensboro, NC in  |  Flag
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Hi Chris,

Open-ended mutual funds continually offer shares, and an investor is able to buy the shares on a daily basis directly from the fund company itself (even when purchased through an intermediary like a broker). The price (NAV - "Net Asset Value) of the shares are set daily, usually after market close, after all of the portfolio's holdings are tallied up and divided by the number of outstanding shares. The ticker typically has 5 letters.

Closed End mutual funds, on the other hand, do not continually offer shares. They will occasionally offer shares - but usually when you buy a closed end mutual fund, you are buying the shares from another investor - or perhaps a "market maker," a broker who has stocked up on the shares for later sale to investors. So - the closed end mutual fund share price has an added element of supply and demand built into it. You may be able to buy the shares at a discount to it's actual NAV - or you may have to pay a premium for the shares. Theoretically, there is an advantage of buying the shares at a discount to it's NAV - in the event the fund liquidates, you may have bought the shares at a lower price than its actual value, and therefore make a profit. However, unless the fund liquidates, keep in mind that the actual premium/discount price that you receive upon sale to another investor will also be set by the supply and demand of the market at that time.

I have seen some closed end mutual funds offer a higher yield than open-ended ones of the same type. I suspect that because of a more predictible cash flow (the manager does not have to manage for liquidations) the closed-end fund manager may be more willing to take on additional liquidity risk which can enhance yields (by entering into limited partnerships or buying illiquid bonds). Additionally, since the closed-ended funds do not have to pay for a distribution channel like the open ended funds do (ie - wholesalers, prospectuses, brochures, continual marketing costs, etc) then their internal expense ratios are usually lower - often translating to a higher yield for the investor.

However, there is no free lunch in the market. For every benefit, there is a price. In this case, the price is that most closed end mutual funds are slightly more volatile than open-ended funds of the same type. So, if you are looking for higher yields, then the closed-ended funds may make a nice addition to your portfolio. On the other hand, if you are looking for reduced volatility, then open ended funds might be the better answer.

Typically, you also must purchase a separate database for adequate evaluation of closed-end funds. The data is much harder to find than the typical open-ended fund database since it is usually used by brokers instead of retail investors.

Jon Castle http://www.WealthGuards.com

Comment   |  Flag   |  Nov 26, 2012 from Jacksonville, FL

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