The Case for Closed-End Funds

You don’t hear much about them, but closed-end funds offer a way to buy a good portfolio of securities, often for cheap. When markets fall (as they recently did and will again) CEFs can be attractive alternatives.

Few opportunities are as easily identified as the closed-end mutual fund. The trouble is, not many investors understand – or are aware of – this investment vehicle. Since you must know what you own, let’s examine the pros and cons of these investments.

The closed-end fund sounds like a mutual fund, but doesn’t walk, talk or look like the one people are most familiar with – the open-end mutual fund, commonly found in 401(k)s. Like these traditional mutual funds, a closed-end fund owns a basket of investments, often stocks or bonds. Its manager decides when and what to buy or sell within the basket, based on the objectives stated in its prospectus. Just like a normal open-ended mutual fund.

However, here’s where a closed-end fund differs: You buy it on an exchange, just like individual stocks. When a CEF is created, it has an initial public offering, similar to a publicly traded company. It issues a fixed number of shares for trading on the open market, and then no more. Open-ends can issue more shares as their assets expand.

Similar to individual stock holdings, CEF owners must find a willing buyer on an exchange when it is time to sell. You buy and sell conventional mutual funds from their sponsor, fund companies like Fidelity or Vanguard.

But with CEFs, the issuing company does not redeem them, like an open-end fund does and this creates the likelihood that the CEF can have a dislocation of price to value. Most often, this situation occurs at times of panic and that’s when potential opportunity exists. The CEF occasionally trades for a premium (that is, for more than what the underlying securities are worth).

But more often, it trades at a discount, where underlying assets are worth more than the current selling price. All the top 20 CEFs that investment research firm Morningstar lists are trading at a discount, some of them 15% or 16% below asset value. The reason is that many cover emerging market nations, whose stock markets are down lately, or U.S. municipal bonds, when many local governments are still struggling, post-recession.

With an open-end fund, shares are sold back to the fund and redeemed for cash. This is very important. Open-end fund managers normally keep some cash available to pay departing investors. But in volatile times, people can panic. An increase in redemptions can force the open-end manager to sell underlying investments, perhaps in a bad market, to raise the additional cash needed.

That’s not a problem with a CEF. The fund’s value fluctuates on the open market. Yet the CEF’s manager determines when to buy and sell the fund’s underlying securities, without worrying about redemptions.

Like all investments, CEFs offer positives and negatives. Many times, CEFs can employ leverage and you want to know that going into the fund. If bad news crops up and the underlying investments tank, the CEF price will, too – and all the debt it carries will hurt the fund.

Also, while the distributions CEFs throw off to investors – often north of 5% – interest and dividends don’t make up all of the payouts. Some of the income is from gains made selling securities, which could result in higher taxes for you if the manager trades a lot.

Don’t confuse closed-ends with exchange-traded funds. Although both trade on exchanges, passively managed ETFs usually track stock and indexes; CEFs are actively managed, so how they fare is in the hands of a manager and his strategy. Plus, the components of an ETF are publicly available daily, and CEFs are more opaque.

While closed-end funds have a similar name to their open-end brethren, they hold their own set of unique characteristics. Your job on sunny days is to know what you would sell and to know what you would buy in given market scenarios. You can check out individual CEFs on Morningstar or at CEFConnect.

I suggest you start considering a list of CEFs in case opportunity raises its head. As always, know what you own.

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Written by Joseph “Big Joe” Clark, CFP, who is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He teaches financial planning at Purdue University and is the host of Consider This with Big Joe Clark, found on WQME and iTunes. He is a Registered Principal offering Securities and Registered Investment Advisory Services through World Equity Group, Inc, member FINRA/SIPC. Big Joe can be reached at bigjoe@yourlifeafterwork.com, or (765) 640-1524. Follow him on Twitter at @Big Joe Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.

Securities offered through and by World Equity Group Inc. Member FINRA/SIPC. Advisory services can be offered by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.

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