When investors speak of mutual funds, they almost always refer to a specific class of mutual funds known as open-end mutual funds. Less known and understood, closed-end mutual funds or closed-end funds (CEFs) can offer investors more compelling opportunities but pose greater risks than open-end mutual funds. Closed-end funds provide investors the ability to buy discounted assets “on the cheap” and amplify investment income through low-cost leverage. However, CEF discounts and leverage serve as a double-edged sword that can cut investors particularly deep in bear markets.

This article covers the basics of closed-end funds, including the following:

• How closed-end funds work and why investors buy them,
• Key risks of closed-end funds,
• Where to find information on closed-end funds and
• Timing of closed-end funds—when are the most opportune times to buy?

Closed-End Funds vs. Mutual Funds

Closed-end funds, like open-end mutual funds, invest in assets on behalf of their shareholders. Asset classes include stocks (U.S., international and sector funds), bonds (municipal, convertible, high-yield, international and Treasury inflation-protected securities, or TIPS), a mixture of stocks and bonds (balanced funds), covered calls, preferred stocks, real estate investment trusts (REITs) and commodities. Just as is the case for open-end mutual funds, two key factors for choosing CEFs are long-term historical performance and the expense ratio (annual fee as a % of assets).

Closed-end funds differ from standard open-end mutual funds in three main ways:

CEFs have a fixed number of shares, while the number of shares in an open-end mutual fund [or an exchange-traded fund (ETF)] changes depending on investor demand. Because closed-end funds have a fixed asset base, they can more easily buy

illiquid investments (investments that are traded less frequently or are difficult to quickly buy and sell). CEFs can also more easily borrow money against their asset base, with the borrowing leading to financial leverage.

Closed-end funds are traded on the open market. Investors buy and sell CEFs throughout the day in the same manner they buy and sell common stocks and ETFs. This intraday trading differs from open-end mutual funds, where investors buy from and sell shares to (redeem from) the mutual fund company using the end-of-day net asset value (NAV).

Because CEF transactions occur between investors, closed-end funds trade at a market price that is typically at a premium or discount to the NAV of the fund. Also, low trading liquidity can be an issue with some CEFs, making it difficult to buy or sell many shares without unfavorably moving the price.

Buying a Closed-End Fund at a Discount

One of the traits that make closed-end funds attractive is the ability to buy a dollar’s worth of net asset value for less than a dollar. Such situations create the potential for capital gains to be realized both from positive returns for the CEF’s portfolio and a narrowing of the CEF’s discount to its NAV.

The formula for calculating a CEF’s premium/discount (P/D) is:

P/D = (Market Price ÷ NAV) – 1

For example, say a closed-end fund trades with a market price of $11 and has a net asset value of $10. This fund would trade at a 10% premium [($11 ÷ $10) – 1 = 0.10]. A CEF trading with a market price of $9 and NAV of $10 trades at a 10% discount [($9/$10) – 1 = –0.10].

I like to look for closed-end funds trading at discounts, particularly income funds, as it means that I have more assets working for me than what I paid for the CEF. Whether a closed-end fund trades at a premium or discount is based on supply and demand for that CEF. I’ve found supply and demand to be influenced by the following factors:

• Overall market sentiment and popularity of the asset class in which the CEF is invested;
• Historical price and NAV performance;
• Leverage and risk (important in market downturns);
• Seasonality, including tax-loss selling;
• The reputation of the CEF manager, including both investment ability and efforts to keep the discount small;
• CEF expense ratio (extremely expensive funds tend to trade at large discounts);
• Dividend yield (higher-yield funds tend to trade at smaller discounts); and
• Liquidity (certain funds with low trading volumes can trade at large discounts).

Historically, the majority of CEFs have traded at discounts, although premium CEFs are not uncommon.

Use of Leverage to Boost Income

One key CEF feature, particularly of bond closed-end funds, is leverage. Bond CEFs borrow money at lower short-term rates (rates lower than what individuals borrow at) and invest this money at higher long-term rates to earn additional income. Leverage thus allows closed-end funds to pay higher interest/dividends than standard open-end mutual funds.

CEFs typically achieve leverage by borrowing money through issuing debt or preferred shares. The amount of debt or preferred shares a closed-end fund can borrow is limited by the Investment Act of 1940 to a maximum of one-half (for preferred stocks) or one-third (for debt) of total managed assets. Translating asset ratios to NAV ratios means that a closed-end fund can borrow up to $1.00 for every $1.00 of NAV if using preferred stocks and up to $0.50 for every $1.00 of NAV if using debt.

Not all closed-end funds use leverage but most bond CEFs do.

Discounts and Leverage Risk in Downturns

With market sentiment a key driver of CEF discounts, it should be no surprise that closed-end funds trade at larger discounts during market sell-offs. For example, a closed-end fund that normally trades at a 5% discount may trade at a 15% discount in a bear market sell-off. See Figure 1 for examples of discount behavior during market panics.

Discounts enable investors to acquire more shares of a closed-end fund for a given amount of available dollars. They hurt existing shareholders of the CEF by reducing the quoted value of their holding. Should a CEF shareholder need to sell the fund during a downturn, they run the risk of selling at a bigger discount to NAV than they purchased the CEF at.

Just like discount risk, leverage risk tends to amplify price volatility and underperformance in market sell-offs. For example, if an unleveraged fund loses $1.00 in NAV, a leveraged fund borrowing $0.50 on the $1.00 would lose $1.50. In severe bear markets, some CEFs have lost enough assets to be forced to sell investments and reduce leverage in order to maintain the Investment Act of 1940 asset coverage ratios.

Net-net, a leveraged CEF investor tends to experience the bear market declines amplified by discount widening and leverage. The heightened risk can make buy-and-hold investing in CEFs more challenging. For this reason, I and many other investors take a more active approach to CEF investing—buying closed-end funds when discounts are wide and selling them when discounts are narrow.

Even buy-and-hold CEF investors should understand the risks of leveraged closed-end funds to avoid buying the most aggressively leveraged funds and then feeling forced to sell these CEFs at bear-market lows to preserve their investor capital.

Where to Find CEF Information

I think the best overall data source on closed-end funds is CEF Connect. This free site (with registration required for some features) is operated by Nuveen and has several useful tools:

• A Fund Screener that lets you screen by asset class as well as sort and set parameters on items like expense ratio, discount, leverage, performance, dividend yield and a host of other factors.
• A Quick Search lookup that pulls up information on a specific fund, given the fund name or ticker. The site provides tabs for Overview, Fund Basics, Pricing Information (including historical discounts), Performance and Portfolio Characteristics.

Once you have found a closed-end fund to consider buying, I recommend you get informational material directly from the CEF’s website. CEF Connect has a link to the fund company website on its Fund Basics page, but you can also use Google to find it. Once on the company website, I look for all fund materials, including the annual and semi-annual reports, where I try to learn about strategy, portfolio holdings, expenses and performance. CEF Connect is not always 100% up to date for all CEFs, so I go to the fund company website to get information “straight from the horse’s mouth.”

I also look for net income information for bond and other fixed-income CEFs. Bond CEFs report net investment income per share, which I compare with dividend per share. Bond CEFs also report undistributed net investment income (UNII), which is the accumulation of income that has not yet been paid out. If UNII is negative, more income has been paid out than earned.

All else equal, bond CEFs with net investment income greater than the dividend and positive UNII are better to own than those with net investment income less than the dividend and negative UNII. CEFs with the former (greater NII and positive UNII) may raise dividends, while CEFs with the latter (less NII and negative UNII) may reduce dividends.

That said, these measures are not 100% accurate for predicting dividends. For example, some CEFs pay fixed managed distributions that are greater than the actual amount of income earned. With such distributions, the hefty dividend yield may be deceiving, as investors could be partially getting their money back in what is deemed a return of capital. [Editor’s note: A return of capital distribution can add a layer of complexity to taxes, as it reduces the cost basis of the shares owned.]

One note on expenses: I deduct leverage expense from the expense ratio because the leverage expense generates an even greater amount of income. However, even with that adjustment, CEFs tend to have higher expense ratios than open-end mutual funds.

Opportune Times to Buy

As shown in Figure 1, CEF discounts tend to widen during market panics. As such, market panics can be an opportune time to buy CEFs. However, investors must still be aware of leverage and sector risk. For example, several leveraged CEFs that invested in energy master limited partnerships (MLPs) lost most of their value during the coronavirus pandemic sell-off and were forced to both reduce leverage and sell portfolio holdings near the bottom of the market.

From a seasonality perspective, the fourth quarter has historically been the best time of year to buy closed-end funds, as shown in Figure 2. Like the January effect for small-cap stocks, CEFs tend to sell off at the end of the year and rebound during the new year. This has led to attractive buying opportunities in October through December. This seasonal effect tends to be more pronounced in closed-end funds that have declined during the current calendar year as investors sell them for tax losses, leading to depressed prices and larger year-end discounts.

Conclusion

For those seeking to earn higher yields than available from open-end mutual funds, closed-end funds can be enticing due to their low-cost leverage and higher dividend yields.

That said, neither CEFs nor the assets they invest in are cheap as I write this. As of June 28, 2021, U.S.-based CEFs traded at a –2.6% median discount, which is narrow relative to the historical averages. Bonds themselves are expensive, with the 10-year U.S. Treasury yielding less than 1.5% and credit spreads at low levels. Additionally, stock market indexes such as the S&P 500 index are trading at high price-earnings (P/E) ratios.

Thus, the current risk-reward trade-off of CEFs is less promising than usual. As previously stated, closed-end funds offer the most upside when they trade at wider-than-normal discounts to NAV and when the assets they own have high appreciation potential.

Acknowledgments: I would like to thank Almitas Capital for providing access to historical closed-end fund data. 

Related

Bonds

Closed-End Bond Funds Versus Individual Bonds: A Case Study

Related

Computerized Investing

Researching Closed-End Funds

Related

Feature

Using Seasonal and Cyclical Stock Market Patterns