Why Do Closed-End Funds Lose Money?
A closed-end fund is a mutual fund that allows portfolio managers to raise funds through an initial public offering (IPO). Investors take note: A closed-end fund is not an investment product but rather a type of investment company. Investors buy shares in the company, and then the company uses the money raised from investors to purchase securities that align with the fund’s investment strategy. The fund manager picks the strategy and decides how much risk to take.
Because closed-end funds rely on a manager, they usually come with high fees. The word “closed” refers to the fact that once a fund conducts its IPO, it does not sell additional shares. However, these funds can still issue preferred shares, and they can also conduct secondary share offerings, potentially diluting the value of the shares purchased by IPO investors.
Closed-end funds can be tricky, and investors should be wary of these often complex products. If a broker recommended that you buy shares of a closed-end fund but did not fully disclose their risks, a securities attorney could help you take steps to recover losses.
Investors may want to buy shares of a closed-end fund because of distribution rates as high as 6%. FINRA warns that investors should know that distribution rates are different from interest. The distribution does not necessarily come from interest generated on the investment but may be simply a return of capital—i.e., the investor’s original payment. Distributions may also vary from one month to the next. Investors should ask their brokers if a less complex investment could just as easily fit their investment goals.
Open-End Funds vs. Closed-End Funds
Open-end funds are much more popular than closed-end funds. They are also less likely to invest in risky alternative investments. The price of their shares depends on the value of their portfolio, divided by the number of shareholders. Closed-end funds, however, derive their value from market demand. Open-end funds can issue shares whenever they choose, while closed-end funds only offer shares during their IPO.
How Do Closed-End Funds Generate Returns?
Closed-end funds generate returns by investing in a variety of securities and financial products. They typically pay distributions to investors monthly or quarterly, and investors can sell their shares on the secondary market. All closed-end funds are subject to SEC registration and oversight, and shares of closed-end funds may trade on major stock exchanges such as the NYSE or NASDAQ.
Why Do Investors Want Closed-End Funds?
When interest rates are low, investors look for riskier strategies to earn higher returns. Closed-end funds are also often sold at a discount on the secondary market, and the price of the closed-end shares is considerably less than the underlying assets. But despite these potential advantages, closed-end funds are not nearly as popular as lower-risk, lower-fee investment funds.
How Can Closed-End Investors Lose Money?
While closed-end funds can be profitable for investors, investors can also face significant losses. Several factors can lead to losses for closed-end fund investors, including the following risks:
- Closed-end funds generally are not required to buy back shares from investors. So, if there is no interest in the secondary market, investors may not be able to sell their shares.
- Closed-end funds can hold a greater percentage of illiquid securities than mutual funds and other types of investment vehicles. When closed-end funds invest in illiquid securities, they risk losing money without a way to stymie their losses.
- Portfolio managers can have different levels of acceptable risk and volatility. Unlike investment advisors, portfolio managers do not have to take investors’ personal risk profiles and financial circumstances into account.
- Closed-end funds might tempt investors with higher yields, but they attempt to produce higher yields using leverage, aka borrowed money. This increases the risk to the investor.
- The fees closed-end funds charge can be excessive, especially during an IPO. These fees can reduce (or eliminate) investors’ returns, and investors must pay these fees regardless of a fund’s performance.
FINRA Fines Firm Over Unsuitable Closed-End Funds
Firms are required to supervise their brokers and catch unsuitable closed-end fund recommendations. FINRA fined Ameriprise $100,000 following allegations that the firm had not adequately supervised one of its broker’s trading recommendations involving closed-end funds. Because of their sales charges, closed-end funds are not suitable for short-term trading. And yet, the broker in question allegedly engaged in a pattern of short-term trading with closed-end funds in sixteen customer accounts. Even though a supervisor flagged the broker’s trades, no action was taken.
Closed-End Fund Fraud
Brokers owe it to their customers to explain exactly how the closed-end fund will use their money. If your entire investment goes toward fees for the brokerage and other administrative charges, the closed-end fund probably isn’t worth your money. Additionally, brokers owe it to their investors to know how closed-end funds work and how best to manage them.
Speak with an Investment Fraud Attorney
Kurta Law is a national investment fraud law firm that exclusively represents defrauded investors. To discuss your closed-end fund fraud case with an attorney in confidence, call 877-600-0098 or request a free consultation online today.