Posted By: CFP&WM On: Jun 12th, 2012 In: Money Matters

Closed End Funds: The Too-Well-Kept Secret

Most investors are familiar with open-ended mutual funds, which are bought and sold at the end of the day based on the Net Asset Value (NAV) of the fund’s holdings. As new money comes into these open-ended funds, more shares are issued by the mutual fund company.

But too few investors have ever heard of a Closed End Mutual Fund (CEF), which is unfortunate since they can be a beneficial investment option for some investors.

CEFs are similar to open-ended Mutual Funds in that they own a collection of investments (stocks, bonds, REITs, etc.), however the number of shares do not increase or decrease based on demand. CEFs start with a fixed pool of dollars with which a fixed number of shares are issued, and that number does not change over time.

Because the numbers of shares are fixed, CEF shares are bought and sold in a manner similar to a share of regular stock. One main advantage of this structure is that the price of the CEF is determined by the market, not the value of the underlying investments. This means, essentially, that it is possible to buy a collection of stocks or bonds at a discount to NAV, and to sell them at a premium to NAV.  Prices for shares of conventional open-ended Mutual Funds always track exactly to the NAV.

Adding CEFs to a diversified portfolio could provide increased tax-free income with a leveraged muni bond fund (ex. AKP, VCV, NAC), enhanced dividend yields with a covered call or preferred stock CEF (ex. FVT, PDT, JGV). A CEF can also provide exposure to alternative asset classes in an actively managed fund that can be purchased at a discount to the NAV.

Gary Cohen, a Financial Planner and Investment Fiduciary in CA, has personally invested in CEF’s for some time and has the following insights.

CEF advantages include:

  1. No big inflows of cash chasing performance or redemptions when investors begin jumping ship due to a poorly performing fund.
  2. Stays fully invested during market cycles since no cash is needed to redeem shares.
  3. Can purchase and redeem CEFs throughout the trading day.

CEF disadvantages include:

  1. Typically, a very small number of shares trade in a given day, meaning large orders can affect prices.
  2. Wider bid/ask spreads than is typical for mutual funds.
  3. Possible higher expense ratios due to the smaller capital pool being managed.
  4. Some CEFs are somewhat more expensive versions of conventional mutual funds, but others use the inherent CEF structure to provide distinct advantages which could include:
    • Leverage:  CEFs can borrow against their holdings to increase returns (and concurrently increase risk).  Typically, CEF bond funds will leverage 20-40%, boosting yields by 1% or 2% over conventional funds.
    • Covered call writing:  Some CEFs use a covered-call strategy to boost yields and income, trading capital appreciation for current income.
    • Preferred stock investing: Some CEFs can arbitrage among preferred stocks, bonds and common stock to increase current income and provide capital appreciation.
    • Investing in alternative assets like REITs, commodities, floating rate notes or other “exotic” investment classes.

Some guidelines for investing in CEFs:

  1. Buy at a discount or even at par, but never at a premium.
  2. Always buy and sell in small quantities using limit orders. Never buy or sell more than 1,000 shares at a time. Plan to buy or sell over a number of days to minimize the effect on prices.
  3. Use leverage wisely; leverage low risk investments (e.g. AAA muni bonds or blue chip stocks) but not speculative investments.
  4. Understand that most CEFs provide higher levels of current income but that often comes at the expense of long term capital gains.
  5. Avoid investing in CEFs that have been returning capital and not earning their distributions via investments or trading activities.
  6. Do not automatically invest dividends and capital gains distributions.  The purchase of CEFs should be a conscious decision, not automatic, since their prices can move significantly.

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