Understanding closed-end fund expenses

NEW YORK (Money magazine) -- Question: Why do closed-end funds often have higher expenses than regular open-end mutual funds do? -- Derry Eynon, Fort Collins, Colo.

Answer: You're right that closed-end funds - which, unlike the more common open-end variety, issue a fixed number of shares and trade throughout the day like stocks - have higher expense ratios on average than standard funds.

That's partly because they can't easily gain economies of scale by adding shares. Another reason: They have more leeway to invest borrowed money.

Since a fund's management fee is calculated as a percentage of the amount of assets managed - not money invested - that larger portfolio means higher closed-end expenses per share.

About 88% of closed-end bond funds are leveraged, as well as about half of closed-end stock funds. For investors, this leverage can boost yields on bond funds and income-oriented stock funds, and returns on any type of fund. But it also creates additional risk, says analyst Cecilia Gondor of Thomas J. Herzfeld Advisors.

Also, while regular mutual fund shares are priced to exactly match the value of a fund's underlying assets, swings in market demand for a closed-end fund's limited number of shares can push their price above or below their net asset value (NAV).

Currently closed-end shares are on average discounted about 2% from their NAV. Sounds nice, but actually they're more expensive than their historical average discount of 4%.