- Net asset value (NAV) is a basic performance measure for any investment fund. NAV is the total value of the underlying securities held by a fund, minus any fund charges. The value of each underlying security is that security's market trading price. NAV changes over time as prices of fund securities change. NAV may also change when fund managers sell some holdings and replace them with new securities. But because closed-end funds do not redeem shares for existing investors, managers change fund portfolio compositions only based on the best investment opportunities. For open-end mutual funds, whenever investors request redemption of fund shares, funds have to sell some holdings for cash, which may negatively affect fund NAV.
- Share price of mutual funds is equal to fund NAV as there is no active trading of mutual fund shares, and they can be bought and sold only through fund companies. But shares of closed-end funds are traded on stock exchanges similar to regular stocks. As a result, share price of closed-end funds can be higher or lower than their fund NAV, depending on market force of supply and demand. Based on market conditions, investors of closed-end funds can pay a premium or discount to fund NAV when buying fund shares. Conversely, existing investors may see their investment rise above or drop below fund NAV even though there is no change made to underlying securities.
- Many closed-end funds are marketed as income-producing investments that promise to distribute regular payments to investors. Such a stated rate of return, or yield, becomes a common performance measure that investors use to compare different funds. However, when fund earnings cannot cover the amount of planned distributions, funds may have to sell some of their holdings, making part of the distributions a return of investor capital but without investors' knowledge. Maintaining a level of seemingly satisfactory yield may actually hurt fund performance in the long run if future capital gains cannot make up the loss of capital base.
- By law, closed-end funds, conducting no sale of new shares after initial offering, are permitted to borrow money to expand fund operations. Open-end funds, on the other hand, can rely only on attracting new investors for expansion. When investments are successful, performance returns can be largely enhanced by using such a financial leverage. The Investment Company Act of 1940, which regulates investment companies like closed-end funds, requires formal disclosure of some financial leverage to regulators. Other borrowing activities may be reported only in the fund balance sheet. Without carefully studying the balance sheet, investors can be misled by the reported above-normal performance, unaware of the potential risks posed by using financial leverage.
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