Investors need be wary of buying stock in closed-end companies. They tend to grow much more slowly than their open-end counterparts, and an investor with limited capital can find himself out of luck if he is unable to buy additional shares at a reduced price.
Some closed-end companies have fancy financial structures. In one of them an investor can take his choice among bonds, two classes of preferred stock, common stock, and finally he can buy an option, called a warrant, to buy common stock. However, several of the closed-end companies have only common stock outstanding, and the trend is in that direction.
On common stock in a closed-end company, the market price per share bears no automatic relationship to the company's asset value. The price may be higher or lower than the asset value, depending on the consensus of opinion in the market at that time. Newspapers publish the bid and asked prices, but not the asset value per share of closed-end companies, so if a buyer wants to know how much premium or discount is in the price, he must make special inquiry.
In a closed-end company, when an investor uses its past-performance record as a guide to future results, he needs to make careful allowance for the fluctuating gap between asset value and market price. Suppose a man bought stock at $7 a share, and he can sell now for $22, more than three times his cost. He bought at a discount of 30 percent, the asset value then being $10. Now the price includes a 10 percent premium over the asset value of $20. When he looks to the future, is the premium going to keep on rising, so that the price will continue to rise faster than asset value? Or will the premium disappear, and die stock again sell at a discount? A man's reaction to this premium-discount element in the price depends upon how much of a gambler he is.
With rare exceptions, a closed-end company pays capital-gain dividends in cash only. To offset this, at irregular intervals a company may invite its stockholders to buy additional shares at a price below the current market price. A stockholder unable to take advantage of such an offer is out of luck.
A closed-end company offers no arrangements for installment buying of its stock, or for periodic withdrawals. Some brokers offer a plan for monthly purchases of any listed stock, including closed-end investment companies, but this is a primitive arrangement compared to the mutual-fund plans.
A closed-end company may issue new shares once in a while, but its growth in assets is slow compared to an open-end company with a large number of local representatives continuously selling new shares. In principle, this has no effect on a company's performance; but practically, it appears that the comparatively slow growth potential of a closed-end company gives its managers less incentive to make a good showing, and it does not tend to attract able, ambitious men to join its management.
In general, being a shareholder in a closed-end company is a curious mixture. Theoretically a company's assets may be just as well diversified and skillfully managed as in the best mutual fund. But the method of pricing its shares brings in a complication and speculative aspect not present in mutual funds; and in the companies with the more fancy financial structure, the speculative risk is still greater.
Just like in music and art, the more complicated the piece, the greater the room for error. It is therefore our advice that investors look on closed-end companies with a wary eye and perhaps keep their money in their pocket and wait for something more lucrative to come along.