What to Know About Closed-End Funds Before You Open Your Checkbook

Closed-end funds are not for everyone.

They buy the same things as other funds but issue a limited number of shares that are traded on major markets like a stock and valued based on how the market feels about the portfolio. (In newspapers, open-end funds are called “mutual funds”; closed-end funds are listed with individual stocks.)

As a result, if the market thinks management is brilliant, it may bid up the closed-end fund so that shares cost more than the underlying value of the holdings. Conversely, if the market is cool to the fund, its shares are discounted, in effect making it possible to buy $100 of stock for, say, $90.

Other key differences between closed-end and open-end funds:

* Closed-end funds have more liberal investment rules. About 60% of the closed-end funds tracked by CDA Wiesenberger Inc. can leverage their holdings, essentially the way an individual borrows against his or her holdings to buy even more.

These borrowings can turbocharge or stall returns, depending largely on short-term interest rates. When rates fall, the fund gets a boost; when rates rise, the fund sags.

* Closed-end funds have a fixed asset base. This makes them particularly good for investments in tiny sectors, private placements and illiquid foreign markets.

An open-end emerging-markets fund, for example, might see a flood of cash after a hot year. Faced with only so many viable investment options in Malaysia, for example, the fund may turn to other alternatives and stray from its objectives.

The closed-end fund in those hot areas doesn’t take on extra cash. Instead, demand bids up the price, narrowing the discount or creating a premium. That’s a win-win situation--the investor wins first with the fund’s hot assets and wins again because those holdings are scarce and in demand.

Similarly, a closed-end fund with bonds at attractive interest rates is practically locked in to those returns, whereas an open-end fund with the same holdings might dilute its returns when new cash comes aboard, since the new cash may have to be invested at a lower rate of interest.

For those reasons, the majority of closed-end funds concentrate in bonds or in niche markets, according to Lipper Analytical Services.

* A discount can be a closed-end fund selling point. The idea is that shares someday will trade at a price equal to its underlying assets, realizing the discount and paying out the extra $10 that you didn’t pay when buying $100 of assets for $90. Or, although rare, the fund may convert to an open-end fund with shares priced at the net asset value, giving investors an instant boost.

* Closed-end funds do not have the same yield-reporting requirements as open-end. As a result, yield information can vary and is often misleading if compared with other investments, albeit legally so.