Closed-end funds are not nearly as popular as open-end mutual funds. According to Morningstar Inc., closed-end funds have $262.1 billion in assets, compared to open-end mutual funds which have $12.7 trillion in assets.
A closed-end fund raises a specific amount of capital via an initial public offering (IPO). Once a fixed amount of shares are issued, there are no additional shares available. After the selling of shares is completed, the fund trades on an exchange, such as the New York Stock Exchange (NYSE) or NASDAQ. A closed-end fund is actively managed and usually focused on something specific, such as a sector, industry, blue chips stocks, municipal bonds or commodities. The performance of a closed-end fund is based on the performance of the underlying assets as well as demand (or lack thereof) for the fund. (For more, see: An Introduction to Closed-End Mutual Funds.)
A closed-end fund is a public offering so it must register with the Securities and Exchange Commission (SEC). Since the fund is actively managed by an investment advisor, that investment advisor must also register with the SEC.
With a closed-end fund, investors must sell shares at the current market price. This differs from an open-end fund, where the fund's shares are priced at net asset value (NAV). A closed-end fund might trade at a premium or a discount, which often depends on several factors, included optimism (or pessimism) in the investment advisor, expected future fees and expenses, leverage, liquidity, and the underlying assets. Leverage is an important factor. If a closed-end fund takes on more leverage, it will lead to access to more capital and the potential for higher returns. On the other hand, it could also lead to steeper losses. Leveraged positions tend not to perform well when the market it tracks suffers. This situation can be made even worse if interest rates move higher, which will make debts more difficult to pay off. (For more, see: What is a Mutual Fund's NAV?)
Closed-End Fund Options
Financial advisors looking to recommend closed-end funds to clients might want to consider ones that have withstood the test of time. Here are a few examples.
Adams Diversified Equity Fund, Inc. (ADX)
The Adams Diversified Equity Fund was formerly known as The Adams Express Company. It has been around since 1929 and its focus is on U.S. growth stocks.
Expense Ratio: 0.66%
Top five holdings (net assets in parentheses):
Apple Inc. (AAPL) 5.2%
Adams Natural Resources Fund, Inc. (PEO) 3.3%
Walt Disney Company (DIS) 2.6%
Google Inc. (GOOG) 2.5%
Wells Fargo & Co. (WFC) 2.5%
The Gabelli Equity Trust Inc. (GAB)
The Gabelli Equity Trust focuses on the long-term growth of capital with income as a secondary objective. This fund seeks to invest in undervalued companies that offer above average potential for growth. The Gabelli Equity Trust has been around since 1986. (For more, see: Unlocking Value in Closed-Ended Funds.)
Expense Ratio: 1.33%
Top five holdings:
Rollins Inc. (ROL) 2.58%
Honeywell International Inc. (HON) 2.12%
American Express Company (AXP) 1.90%
DIRECTV (DTV) 1.81%
MasterCard Incorporated (MA) 1.60%
General American Investors Company, Inc. (GAM)
General American Investors Company implements a bottom-up stock picking strategy across global markets. It has been around since 1927.
Expense Ratio: 1.10%
Top five holdings:
The TJX Companies, Inc. (TJX) 7.1%
Apple Inc. 4.0%
Costco Wholesale Corporation (COST) 3.8%
Arch Capital Group Ltd. (ACGL) 3.7%
Gilead Sciences Inc. (GILD) 3.6%
MFS Charter Income Trust (MCR)
MFS Charter Income Trust seeks high current income and also considers capital appreciation. From the fund’s profile: “The trust invests equally in the three sectors of the fixed-income securities: debt securities issued by foreign governments, securities issued by the U.S. government, and high yielding corporate fixed-income securities.” As far as credit quality, its highest exposure is to B-rated bonds (35.01% of net assets). The average effective maturity for the fund is 7.11, with an average effective duration of 5.46 years. The fund has been around since 1989 and has an expense ratio of 0.87%. (For more, see: 20 Investments: Closed-End Investment Fund.)
The Bottom Line
Closed-end funds might not be as popular as open-end mutual funds, but they still offer diversified exposure to high-growth potential and high-income investments. Pay attention to leverage and expense ratios. Higher leverage equals higher potential but increased risk as well. A high expense ratio can eat into income. Additionally, instead of just looking at what the fund is tracking in general, be sure to investigate a fund’s holdings. If they’re stocks, are those companies in hot industries? Are the top and bottom lines growing annually? Is there consistent cash flow generation? What is the company’s debt-to-equity ratio? Has the stock seen recent price momentum? If the fund invests in high-yield bonds, it offers high potential. But higher yield bonds are also higher risk, which is why the yield is high. You are being rewarded for taking on that risk. The funds above were listed here for a reason, which is their ability to withstand the test of time, including some very difficult markets.
This indicates quality management. (For more, see: Open Your Eyes to Closed-End Funds.)
Dan Moskowitz does not own shares in any of the funds or stocks listed above.