Most investors understand open-end mutual funds or mutual funds and are probably familiar with exchange-traded funds (ETFs). Many investors have likely heard of closed-end funds (CEFs) but far fewer actually understand what they are.

Part Mutual Fund, Part ETF

Open-end mutual funds have no limit on the number of shares issued. For example, if you send $10,000 to Vanguard to purchase shares of its Vanguard 500 Index fund (VFINX) you will purchase as many shares as $10,000 will buy on the date they receive your check. They will simply create more shares for you. There are no limits on buying new shares unless the fund is closed to new investors. ETFs can be bought via any broker such as Charles Schwab Corp. (SCHW), Fidelity Investments or many others. Again if you purchase 100 shares of the SPDR S&P 500 ETF (SPY) you will receive the shares at the market price at which they were purchased less the transaction cost. (For more, see: An Introduction to Closed-End Mutual Funds.)

Closed-end funds are a bit different. They are like mutual funds in many respects except when they are created only a finite number of shares are issued, after that there are no new shares issued. New CEFs are usually issued via an initial public offering (IPO). CEFs trade on the stock exchange just like shares of Apple, Inc. (AAPL) or Exxon Mobil Corp. (XOM). There are CEFs which invest in stocks and bonds including munis.

Another feature that is critical to understanding CEFs is the fact that they may trade above the net asset value (NAV) per share of the fund which is known as a premium or below the NAV which is known as a discount. In fact the premium or discount is a key tracking indicator when analyzing a CEF. ETFs can also trade at a premium or a discount to their NAV but at least for ETFs with decent volume and those that track standard indexes this spread is generally negligible. (For more, see: see Open Your Eyes to Closed-End Funds.)

Deep Discounts

The stock market is undergoing a degree of turmoil and many major benchmarks are well off of their highs. As a result, many CEFs are trading at levels that are far under the shares’ net asset value or the value of the fund’s underlying holdings. A CEF selling at a 10% discount means that you are buying the fund’s assets for 90 cents on the dollar. What is more important than the absolute premium or discount at which the CEF is currently trading is the level of premium or discount relative to the CEF’s historical averages.

Leverage

According to Morningstar Inc. (MORN), more than 70% of the CEFs available employ some degree of leverage. In the CEF world leverage refers to a method by which the CEF can magnify both gains and potential losses. Leverage can come in many forms but it generally means the fund managers have issued debt or created preferred shares which serve as a claim or liability against the assets (stocks, bonds, etc.) held by the fund. Leverage here works in a similar fashion to leverage on a corporate balance sheet. While the leverage ratios for most CEFs are lower than for many major corporations, the impact on returns from leverage can be pretty dramatic. Leverage can also be a tool for CEF managers to be able to boost the distributions paid to the fund shareholders. (For more, see: Using Closed-end Funds to Build Your Core at a Discount.)

Distributions

CEFs do not pay income taxes. They pass the tax consequences of their investing activities to their shareholders just like open-ended mutual funds. In order to maintain their tax-free status they are required to pass at least 90% of the net investment income from dividends and interest as well as 98% of the net realized capital gains.

Payments to CEF shareholders are called distributions. These distributions can come from four sources:

  • Interest payments from fixed income holdings
  • Dividends from stocks
  • Realized capital gains
  • Return of capital

The return of capital is a unique and often misunderstood aspect of CEF investing. This can come from valid and positive sources such as a pass-through from holdings in Master Limited Partnerships. It can also be “destructive” in nature such as when the fund doesn’t earn enough to pay its normal distribution level out and the managers dip into the fund’s capital and essentially return the shareholder’s own money to them as a part of the distribution. If a fund does this consistently it will erode the CEF’s value over time. (For more, see: Is it Too Late for MLPs?)

Stable Asset Base

The number of shares issued are fixed so managers don’t have to worry about how to invest an influx of new money which can be a problem for a successful open-ended fund manager. Likewise, there are no redemptions to worry about so there is never a need to have extra cash on hand to meet redemptions as with an open-ended fund. (For more, see: The Right Fund for You: Closed-end or Open-end Funds.)

IPOs

While there are no absolutes it is often a good idea to avoid the initial public offering of a CEF:

  • Unlike with a corporate IPO there is no operating track record for the fund prior to the IPO. Even if the manager is a known commodity there is not a track record for this specific strategy.
  • CEFs almost always trade at a premium to their NAV right after the IPO.
  • The new cash from the IPO must be invested in the fund’s strategy whether or not the timing is right for this investment.
  • Brokers have a high incentive to invest client dollars in these IPOs. It is safe to say that CEF IPOs are often sold rather than bought. (For more, see: Complementing Your Portfolio With Closed-End Funds.)

The Bottom Line

Closed-end funds have been around for a long time but remain a largely misunderstood investment vehicle by many investors and financial advisors. Closed-end funds can sell at a premium to their net asset value or at a discount. It is imperative that investors understand the fund’s strategy and its distribution policies and history. Additionally, the fund’s use of leverage must be understood as well. CEFs can be a profitable investment vehicle provided the investor or their financial advisor knows what they are doing. (For more, see: The Complete Guide to Closed-end and Open-end Funds.)

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