Following on from last month’s post about investment funds (open-end-vs-closed-end-funds), you should now be armed with the knowledge you need to understand what we mean by an open-end (OEF) and a closed-end fund (CEF). So, where you do you go from here? You have some money to invest and want to put it into stocks and shares – how do you decide what’s best for you and your money?

The most logical way to invest in stocks and shares is via an OEF or a CEF as either one will give you the greatest diversification across a variety of assets. Imagine you wish to invest in the UK stock market. You could choose and buy the shares yourself, or you could invest in a CEF or OEF that specialises in UK shares, in which case you will have a professional watching the market all the time and managing the shares in the fund for you. If you wish to diversify further, you invest in a number of funds specialising in other geographical areas or sectors, such as fixed income, commodities, smaller companies or property. You can therefore have a well-diversified portfolio of funds. So, which type of fund do you choose?

Open-end funds

• Advantages
  • You can buy them directly from the fund manager rather than being obliged to have an account with a stockbroker as you do with a CEF.
  • As pricing takes place only once a day there is less volatility in their price than with a CEF.
• Disadvantages
  • On the flip side, because pricing is only carried out once a day the investor does not know exactly at what price he is buying or selling.
  • The annual management fee is normally clear but there are often ‘on-going fund charges’ that are simply added as a percentage and you are rarely told what they are upfront.
  • In certain markets, e.g. property and emerging markets, the underlying shares may go through periods of illiquidity and it is not easy to sell them or consequently the fund itself.

Closed-end funds

• Advantages
  • They benefit from all-day pricing during market hours as the funds are quoted on the London Stock Exchange.
  • OEFs distribute all their income on an annual basis whereas CEFs can keep 15% of their income in a revenue reserve in order to be able to pay dividends during less good times.
  • Over the long haul – say on a 5–10 year basis – performance from CEFs is superior to OEFs. Fund managers are able to take a longer-term view as there is a constant level of cash and the manager does not have to sell investments in order to meet customer sales.
  • Performance is enhanced by gearing, i.e. borrowing to invest in more of the underlying investments assuming the share prices rise. (This can also be a disadvantage as explained below.)
  • Shareholders in CEFs can also benefit from an undervaluation of the shares when the price of the share is at a discount to the ‘net asset value’ (NAV) per share. If the discount narrows and the underlying value of the shares rises, the investor makes an additional gain.
• Disadvantages
  • There is greater volatility of price movement, most likely due to their quotation on the stock market and market pricing based on supply and demand.
  • The effect of gearing on the portfolio: just as profits can be enhanced if prices rise, so losses can be increased if prices fall. There is no doubt that gearing has to be used judiciously.

Which is better – an OEF or a CEF? Sadly, there is no definitive answer to this question and ultimately the choice is down to the investor and their views on the above conditions. However, as a general rule, where there is likely to be reduced liquidity in a particular sector’s shares, then it is best to opt for a CEF. Typical sectors would be property, emerging markets and smaller companies. Otherwise, in the case of liquid company shares (such as the FTSE 100) it simply comes down to the investor’s preferences.

Archiemidas
This article is not to be construed as financial advice. The views expressed above are those of the writer and do not constitute a recommendation to purchase, hold or sell. It must be borne in mind that the value of investments and any income will fluctuate. The value of your investment can fall as well as rise and you may not get back the original amount invested. Past performance is not a guide to future returns.