Most investors know how mutual funds work: investors’ money is pooled and used to buy assets like stocks and bonds. If all goes well, the fund’s share price rises and investors can cash out by redeeming, or selling their shares back to the fund company.

Share price, or “net asset value” (NAV), is figured by the fund company after the market closes each day, by dividing the total value of the fund’s assets by the number of shares outstanding.

But there’s an alternative — closed-end funds, or CEFs.

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“CEF structure has been beneficial to take advantage of key market conditions, especially within fixed income,” says Stephen Vogel, an advisor with Corvus Capital Management in Nashville. “They are popular instruments of yield seekers because of their large distribution yields.”

While open-ended funds create new shares as more money comes in from investors, or dissolve them as investors pull out, a closed-end fund produces a finite number of shares at the start. After the initial public offering, shares are traded on the stock market with prices rising and falling with investors’ views about the assets in the fund and the fund manager’s skill. CEFs are sometimes described as ancestors to exchange-traded funds, but CEFs have a fixed number of shares while ETFs can raise or lower the figure as demand changes.

That means the CEF share price is set by supply and demand, adding a layer of risk and opportunity.

“The price of the fund can vary far from the fund’s net asset value,” Vogel says. “Since the fund is closed, no new shares are created when an investor purchases them, allowing the price the ability to float to a premium or discount to the fund’s NAV.”

Many investors seek funds trading at a discount, figuring the market will come to its senses and boost the price to reduce the discount or even create a premium.

“As an investor in CEFs, we always avoid an IPO,” says Gregory Neer, partner at Relative Value Partners in Northbrook, Illinois. “CEFs launch at a premium to NAV and then typically fall to a discount over time.”

As with open-ended funds, investors must assess the prospects of the stocks or bonds the fund owns, but then must also figure the odds the discount will shrink or the premium expand. Even a shrinking discount can present a hazard if the cause is a drop in NAV.

“Discounts and premiums can be especially pronounced with stock CEFs,” Vogel says. “Corvus Capital doesn’t recommend using CEFs for equity investments. Equity funds are typically volatile on their own and can be expensive in the CEFs.”

For stocks, exchange-traded funds are a better bet, he says. Like CEFs, ETFs trade like stocks, but share prices closely track net asset values.

“Because closed-end funds can trade at discounts or premiums to net asset value, they are more volatile than the equivalent open-end fund,” says advisor and money manager Leland Faust, author of “A Capitalist’s Lament: How Wall Street is Fleecing You and Ruining America.”

Many CEFs use leverage to boost results. While that can raise yield on a bond fund, sometimes to 9 or 10 percent, Vogel says, it also amplifies losses in a downturn.

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“For example,” Faust says, “Enterprise Products, a master limited partnership, currently yields about 6 percent, while a closed-end fund of master limited partnerships is currently paying 10 percent. But, over the last 10 years Enterprise Products stock value has gone up about 100 percent while the shares of the closed-end fund have decreased by about 24.”

Among the hazards: Even though CEFs can be traded throughout the day, it could be hard to sell when you want, as you need a willing buyer. With open-ended funds, the fund company must accept your redemption whenever you want.

“Closed-end funds can be subject to liquidity problems both at the level of the fund and at the level of the shareholders,” Faust says. “This can result in losses if an investor wants to get money back quickly. Also, some of the closed-end funds invest in less liquid assets, so they can experience internal liquidity problems in times of market unrest.”

Who is the ideal CEF investor?

Most experts warn that CEFs are not a good alternative for investors accustomed to a fire-and-forget approach, such as indexing.

“Because of this complexity, they are best used by professional investors and financial advisors who have experience in these types of funds,” Vogel says.

“Investors with small portfolios should stay away,” says Faust, citing complexity and his opinion that CEF’s are most appealing to investors eager to get into the weeds. “If you want to invest in micro-cap or Hong Kong market, perhaps this is useful vehicle.”

“With CEFs, you really need to know what’s going on within the fund,” Neer says.

How do CEFs look today?

“The overall market is currently trading at a discount of 4 percent, but there are pockets of opportunity trading significantly cheaper than that,” Neer says. “Funds that invest in areas like senior loan funds remain attractive, especially if the (Federal Reserve) begins raising interest rates. The BlackRock Floating Rate Strategy Fund is a fund we like, currently trading at a 7.3 percent discount.”

Municipal bond CEFs, he says, are not so attractive, as they’re trading at a discount of only about 0.55 percent.

“We believe investors will have the opportunity to buy these at much larger discounts in the future,” he says.

Warren A. Ward, a planner with WWA Planning & Investments in Columbus, Indiana, says bargains are scarce today.

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“Last time I looked, I was unable to find an otherwise suitable fund trading below its 36-month range, so I elected not to sell or buy but to stick with what we already owned,” he says. “I wouldn’t say there’s no money to be made in CEF funds but I would say the easy money is probably gone.”

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Pros and Cons of Closed-End Funds originally appeared on usnews.com