Understanding and Buying Closed-End Funds

The array of financial products facing an investor is mind numbing and include stocks, bonds, mutual funds, exchange-traded funds, closed-end funds, annuities and the list goes on and on.

Market trendsIn this article, we hope to shed some light on closed-end funds, an often overlooked segment of the market. Closed-end funds have properties of both mutual funds and exchange-traded funds but are also unique in a number of ways. Like mutual funds, closed-end funds, or CEFs, are managed pools of assets such as a collection of stocks or bonds. And like exchange-traded funds, CEFs trade on an exchange like a stock does. However, in a CEF, the capital base is fixed and new shares are not created or destroyed when an investor buys or sells into the fund. The benefit of a closed-end fund is that you have a diversified, professionally managed investment pool where the manager is free to focus on investing without having to worry about redemptions from the fund. Not worrying about redemptions is particularly important when investing in illiquid securities like bonds. Below we will touch base on a few key aspects of CEFs that every investor should investigate and be aware of before making a purchase decision.

Closed-End Funds Premiums and Discounts

Because CEFs trade on the exchange, it will have a market price where buyers and sellers can exchange shares. In addition, the underlying assets in the fund have a value, leading to a net asset value or NAV for the fund. These two numbers are rarely the same. When a share price is less than the NAV, the fund is said to be selling at a discount while it is at a premium when the share price is greater than the NAV. A CEF trading at a discount can be a good deal because you can buy a pool of assets worth, for example, $1 for only $0.85. The truth is, there are many reasons why a CEF could trade at a discount. For example, if it has a poor management team or the NAV is based on stale prices. Likewise some CEFs consistently trade at premiums to their NAV. One does need to be careful when buying CEFs that trade a premium because it is likely that the premium will eventually collapse. Likewise, management of a CEF that is trading at a consistent and deep discount faces a proxy battle and it is a potential take-over candidate because, in theory, the assets could be liquidated and investors could be compensated at the higher NAV.

CEF Distributions

Many investors prefer dividend-paying investments as they can earn a steady stream of income. Closed-end funds cater to this type of investor because most offer attractive payouts. In addition to a dividend, it is important to note that some CEFs payouts consist of a return of capital. What this means is that the capital base of the CEF is shrinking when a CEF makes a return of capital, which can be okay in certain situations but it can also be an area of concern. The total distribution rate from a CEF can be calculated in comparison to the fund’s NAV. However, it can also be compared to the fund’s share price. If a fund is selling at a discount, the distribution yield becomes more attractive.

CEF Leverage

CEFs often employ leverage to boost distribution. Investors need to remember that this leverage magnifies returns, both on the upside and on the downside. It can also magnify duration and other common investing risk factors. Typically, a CEF obtains leverage through issuing debt or preferred shares but it may also obtain leverage through the use of derivative securities or tender option bonds.

CEF Initial Public Offering

Like a stock, closed-end funds have an initial public offering (IPO) through which they raise capital and distribute shares. It is usually not advised to buy a CEF during the IPO. The reason for this is that the CEF will typically sell at a premium to net asset value when first launched. Those that underwrite the IPO, that is, distribute it to the investing public, earn what is called underwriting fees. In addition to the underwriting fees, CEFs typically offer a selling commission to the brokers that sell them to the public. These fees drive a wedge between the NAV and offering price, creating an initial premium that can quickly collapse after the IPO, thus leaving investors with a loss. We suggest investors wait and buy closed-end funds in the secondary market to avoid this initial premium bump and the added potential loss.

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