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Offbeat Offerings: Closed-End Funds

by Cara Scatizzi

Offbeat Offerings: Closed End Funds Splash image

Most investors are quite familiar with open-end mutual funds, portfolios of securities that offer diversification and professional management at a low cost even for smaller-sized investors.

Closed-end funds, however, are a sometimes-overlooked alternative. Closed-end funds differ from mutual funds in that once the fund issues shares, those shares are bought and sold in the open market; unlike a mutual fund, the closed-end fund does not itself stand ready to redeem shares from investors wishing to sell their shares. Closed-end fund shares have both a net asset value and a share price, and sometimes trade at discounts or premiums to net asset value.

How They Work

A closed-end fund raises capital by issuing a fixed number of shares, which typically (but not always) are listed on a stock exchange. Once issued, those shares are bought and sold in the open market.

In contrast, open-end mutual funds generally sell their shares on a continuous basis (although some will close to new investors), and shares are purchased and redeemed directly by the fund (or through a broker for the fund) at the fund’s approximate per share net asset value plus any shareholder fees or sales charges imposed by the fund.

Closed-end funds invest in securities in a wide variety of categories—including both stocks and bonds—and are actively managed by professional investment advisors.

The price of a closed-end fund fluctuates according to market supply and demand for the fund’s shares, and with the changing values of the fund’s holdings.

The closed-end structure allows the fund’s manager to work with a stable pool of capital. Because a closed-end fund does not issue redeemable shares nor does it continuously offer shares, it does not have large inflows or outflows of cash, which can be problematic for mutual fund managers, who may be forced to buy or sell securities at inopportune times. Because closed-end funds avoid this problem, their managers can invest more fully and, some argue, be more long-term oriented.

A closed-end fund’s performance and returns are calculated in two ways. The net asset value (NAV) is computed twice daily based on prevailing market rates for the securities held. This performance number can be used to compare with other funds to judge the manager’s performance. Closed-end fund returns are also calculated based on the fund’s market price performance, which would be the return an investor in the fund would experience over the given time period.

Closed-end funds are required to issue a prospectus when issuing new shares. Closed-end funds also will distribute annual and semiannual reports that contain financial statements and information on the fund’s portfolio, performance, and investment goals and policies.

Although closed-end funds do not issue new shares continuously, they may raise new capital, typically through rights offerings. A rights offering is for current shareholders. For instance, if one share gets one right, if you own 10 shares, you would have the rights to buy 10 additional shares. All shares bought through this rights offering are bought at a discount to the current market price, or an average price over a set time period. Sometimes these rights are transferable, meaning the shareholder can sell them in the open market.

Some closed-end managers leverage their common stockholder’s returns with preferred stock or (less common) with loans. The proceeds from the preferred offering are used to invest in additional bonds or stock, depending on the fund type. Municipal bond funds are typically more inclined to leverage than equity funds.

Although leverage can be highly effective in a prolonged bull market, losses are magnified in a bear market. For equity funds, the preferred dividend obligation would be burdensome during extended periods of low equity returns. For municipal bond funds, the yield on munis normally exceeds the cost of the preferred, but the risk becomes evident when rates rise and the preferred’s cost quickly increases.

Types

There are many types of closed-end mutual funds. ETFConnect, a Web site sponsored by Nuveen Investments, tracks over 650 closed-end funds. Funds focus on a wide variety of securities, including common stocks, preferred stocks, high-yield bonds, taxable and municipal bonds, and foreign securities.

How to Trade

Closed-end funds are bought and sold through brokers and typically are traded on an exchange.

The prevailing market price is the price at which you will buy or sell shares. Commissions will vary by broker. Investors can place market or limit orders when purchasing or selling shares.

Investor Suitability

As with mutual funds, closed-end funds can add to the diversity of your portfolio. You might find that a closed-end fund has more potential for higher returns because of the relative small size of the fund, which gives the managers more options and leeway. This can also lead to higher risk as well.

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In addition, the discounts and premiums to NAV add a layer of complexity to the analysis that does not exist when investing in mutual funds. The use of leverage also adds a layer of risk.

Tax Consequences

Like open-end mutual funds, closed-end funds distribute income through dividends, which are taxed as ordinary income, and through capital gains distributions, which are taxed either as taxable income (short-term gains) or at the current maximum of 15% for long-term gains. Some funds will give investors the option to reinvest distributions.

Once shares are sold, the gain (or loss) is taxed as well. You can also hold these securities in a tax-sheltered retirement account.

Municipal bond funds also follow the same tax (or tax-free) rules as an open-end municipal bond fund, which means depending on the exact type of investments, gains may not be subject to federal and/or state taxes.

The Pros

Mutual Fund Alternative
Like mutual funds, closed-end funds offer investors a low-cost opportunity to invest in a professionally managed portfolio of diversified securities.

A Stable Pool of Assets
Because shares are sold from one investor to another and not bought back by the fund itself, there is no need for the fund to hold a large cash position. This means the closed-end fund can be more fully invested in the stock market at any given time.

Another advantage of not accepting unlimited funds from investors means the fund has the ability to invest in smaller, less liquid and possibly more obscure securities than a typical large open-end fund, giving fund advisors more investment options. Be aware that some of these options may carry more risk than a larger-cap, more liquid stock—a blue chip stock, for example.

Discount Opportunities
By taking advantage of attractive discounts, you may be able to earn a higher return on your investment than the fund itself generates on an NAV basis. Closed-end funds can be used as core holdings to profitably augment a mutual fund portfolio, substituting them for the latter when compelling discounts exist.

The Cons

Less Liquid
Closed-end funds are less liquid than typical open-end funds because you must find another investor to complete your transaction, rather than redeeming shares from the fund.

Discounts May Widen
Closed-end funds often trade at a discount to NAV, and those discounts may become greater than when you purchased the fund.

More Complex and Risky
The analysis of closed-end funds is more complex compared to mutual fund investments, and closed-end funds that are leveraged have additional risks that must be understood.

Additional Information

ETFConnect
www.etfconnect.com

ETFConnect tracks data on exchange-traded funds as well as closed-end mutual funds. You can search for funds, see performance data and charts, and compare funds and indexes.

Closed-End Fund Association (CEFA)
www.closed-endfunds.com

The CEFA is a not-for-profit national trade association representing the closed-end fund industry. CEFA offers educational materials for investors as well as comparison tools and a search function to find potential investments.

Cara Scatizzi is a former associate financial analyst at AAII.


Discussion

John from FL posted over 3 years ago:

CEF's... I own many primarily from BlackRock and Pimco.

Their dividends are like clockwork monthly or quarterly and those that maintain or advance in Capital value I keep. If one fails on the Capital side they are sold and replaced with another.

As all are in IRA/SEPs etc they are serving me well.

Funds managed using "Covered Calls" and "Bond Funds" I gladly pay the Management Fee.

Monthly dividends I do not require as income are used to build the share base.

I am certainly open to constructive critique or other in my approach...

tks in advance.


Ralph from ID posted over 3 years ago:

Being fairly new to the realm of Closed-End Funds, I would like to know if you would share your criteria for analysis and limits on evaluating and selecting a CEF for investment.

Thank you.


Patrick from OH posted over 2 years ago:

CEFs are categorized by the types of investments they make. Barron's prints a weekly report on the performance of the most popular CEF and lists their NAV and the current premium or discount along with the return....seems like the best approach is to find funds selling at discount to NAV with acceptable return...their is a possibility of appreciation along with the monthly return as referenced above


Leroy Supowitz from PA posted over 2 years ago:

I am looking for a CEF screening program to screen for:
current discount,3 yr average discount, leverage %, 12 month NAV performance and 12 month price performance, distribution (yield) %, etc.
It could be online or via disk updates and not extravagently priced. I am a novice at computing as well as screening so a decent tutorial would be great.
appreciate any ideas.


Pete K from New Jersey posted about 1 year ago:

Leroy, everything you seek can be found on either cefconnect.com, cefa.com or cef.capitallink.com, which all have either screeners or search mechanisms. The exception might be the 3Yr average discount. CEFConnect offers 52-wk High, Low and Avg. discounts. You could probably compute the 3Yr Avg from the data available.

I built a spreadsheet to extract all this info and more, e.g, leverage used, expense ratio, distribution breakdown, market cap, etc. The sheet uses VBA code and a financial add-in (SMF - free on Yahoo groups) which automates the process for me.

I own 7 CEFs, with plans to add more. There are also authors on Seeking Alpha who are very knowledgeable re CEFs: Douglas Albo, George Spritzer, John Cole Scott, and Robert Lewis.


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