All freely traded liquid markets share common traits related to psychological pressures (fear and greed), but each differs as to fundamental relationships, trading mechanisms, and structural factors. Each market’s individual characteristics must be understood. Once this understanding has been achieved, proper evaluation of similarities or differences, as well as interrelated pricing effects, with other markets can be accomplished.

One market that allows easy application of Drach’s common stock analysis is closed-end funds, also known as publicly traded funds or closed-end investment trusts (CEITs).

Although one of the oldest forms of investment, closed-end funds are among the most misunderstood and consequently often overlooked investment areas. Their origin can be traced back to the establishment of a Belgian fund in 1822; thereafter they flourished, particularly among English and Scottish investors in the latter 1800s. The first U.S. fund was formed in 1893 and, until the time of the stock market crash of 1929, closed-end funds were the dominant form of publically owned investment companies.

FundsThe dominance of closed-end funds ended with the arrival of mass appeal open-end investment companies. There are currently almost 4000 open-end funds with assets well over 11/t trillion dollars, far surpassing the number of publicly traded closed-end funds (almost 400) with assets approaching $150 billion.

Net Asset Value (NAV)

Both closed- and open-end funds share the same fundamental purpose. They are both investment companies; that is, they are companies whose business it is to invest in the securities markets, primarily stocks and bonds. The investor (stockholder) in either type of fund owns a proportionate share of the assets of the investment company.

To determine the value of each share of an investment company (open-end or closed-end) is usually an easy process. Add up the assets at their current market value and divide by the number of outstanding shares.

For example, let’s say the market value of the assets (stocks, bonds, cash, and the like) of a fund is $15,000,000 and there are 1,000,000 shares outstanding. The net asset value (NAV) would be:

$15,000,000 = $15/share

1,000,000 shares

With the number of shares constant, the net asset value will fluctuate with changes in the market value of the assets that the fund holds.

Capitalization

The major difference between open-end and closed-end funds is the method by which they are capitalized.

In open capitalization, when an investor purchases shares, the fund issues new shares, thereby increasing the number of shares outstanding. Conversely, when the investor sells shares, the fund purchases (redeems) the shares, paying the investor the proportional amount of the fund’s assets and reducing the number of outstanding shares. The capitalization is variable. That is, the amount of assets under the fund’s management changes as a result of the net purchases or sales (redemptions) of shares.

In closed capitalization, the investment company has a fixed amount of shares just like an industrial corporation. The shares trade in the open market. As investors buy and sell the shares, the number of outstanding shares remains constant. The capitalization is fixed. That is, the amountof assets under the fund’s management does not change as the result of the shares being traded.

These methods of capitalization might at first seem insignificant. After all, if a fund is going to do well or poorly in its chosen investments, it might be logical to assume that the value of the shares will appreciate or depreciate accordingly. This is not the case. To understand why, we must examine differentials in pricing mechanisms.

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Closed-End Funds