When most passive investors go shopping for investments, they generally opt to put their money in mutual funds, which are technically known as open-end funds. These funds are investment vehicles that are made up of pools of funds collected from many individuals or institutions. The capital is typically invested in stocks, bonds, or money market instruments, in an attempt to produce capital gains and/or income for the fund's investors.

Each mutual fund shareholder participates proportionally in the gain or loss of the fund, and units, or shares, can be purchased or redeemed as needed. Open-end fund shares are bought and sold at net asset value (NAV), and can only be traded at the closing price at the end of the market day.

The main advantage gained by investing in open-end funds is small investors are given access to professionally managed, diversified portfolios of equities, bonds and other securities. These portfolios would be almost impossible to recreate with the small amount of capital that most individual investors have available to commit. Another advantage is that passive investors can put money into these vehicles without having to worry about researching individual stocks or bonds; buying or selling securities; etc. Too, since mutual fund units are bought and sold through the investment company, investors bypass the need to pay hefty brokerage commission fees.

We think the same advantages can be gained by investing in closed-end funds. Despite the obvious similarities in the names, a closed-end fund has little in common with a mutual fund. A closed-end fund is a publicly traded investment company that raises a specific amount of capital through an initial public offering of a fixed number of shares. The fund is then structured, listed, and traded like a stock on a stock exchange. The price of closed-end fund shares fluctuates according to market forces (supply and demand), as well as the changing values of the fund's holdings.

Closed-end fund shareholders earn capital gains (incur capital losses) and receive distributions like holders of regular stocks. Moreover, since the shares of these investment companies are listed on an exchange, investors can buy or sell closed-end fund shares any time the market is open. On the down side, would-be purchasers of closed-end fund shares have to pay brokerage commission fees as if they were buying a stock. Finally, the shares tend to trade at a premium or discount to NAV. Hence, if a fund has a long track record of success, investors may be willing to pay more than the underlying portfolio is actually worth. Conversely, if a fund invests in risky securities or has an aggressive objective, investors may be able to scoop up its shares at a steep discount to the underlying asset value.

Unlike regular stocks, and similar to mutual fund units, closed-end fund shares represent an interest in a specialized, actively managed portfolio of securities, which typically concentrates on a specific industry, geographic market, or sector. Thus, we believe that investors with a limited amount of capital that are willing to do a bit more homework (see below), can build a well-diversified portfolio using only closed-end funds. Passive investors can also benefit from investing in closed-end funds, since they do not have to be concerned with buying or selling individual stocks or bonds. They would, however, have to open a brokerage account in order to purchase the shares of closed-end funds.

There are many different types of closed-end funds out there. There are some funds, such as TriContinental Corporation (TY), that aim to create a well-diversified portfolio of large-capitalization stocks from a broad range of industries. TY shares would be ideal for the aforementioned passive investors looking to dip a toe into the stock market. Conversely, conservative, income-oriented investors may want to look for investment opportunities similar to AllianceBernstein Income Fund (ACG). Most of the capital available to this fund is generally invested in A-or-better-rated bonds that are issued or backed by the U.S. Government. These are just two examples of the types of closed-end funds out there for investors. There are portfolios that invest most capital in debt originated in the Asia/Pacific region; funds that typically invest in high-yield (junk) corporate debt; trusts that use Graham & Dodd’s approach to value investing; etc. So, small investors will have to do some research before finding the closed-end funds that are the right fit, but that search could be well worth the effort.

At the time of this article’s writing, the author did not have positions in any of the securities mentioned.