Introduction
The quest for steady returns with an edge can land you in the camp of closed end funds. Unlike their open end mutual fund cousins and CEFs come with one important twist a fixed number of shares trading on exchanges. This introduction takes you deep into the realm of closed end funds and what their advantages and possible pitfalls are and what key considerations there are before you ever invest. We will unveil different CEF types and highlight best practices that come out of them and and even explore some top performers. So and fasten up your seatbelts and and let’s unleash the power of closed end funds
Closed End Funds
Closed end funds are a very special investment vehicle and one that puts a twist on the familiar world of mutual funds. This creates a unique set of characteristics and considerations for investors.
The following is an explanation of how CEFs are structured and how they work
Capital Structure
After the IPO there can be no increase or decrease in the number of outstanding shares of a CEF. This number does not change because unlike mutual funds a CEF doesn’t continuously issue new shares or redeem existing ones at net asset value (NAV).
Trading on Exchanges
After the IPO and the CEFs trade on exchanges similar to any other individual stock. The share price changes during the day by supply and demand from investors and this price doesn’t necessarily reflect the underlying NAV of the fund.
NAV vs. Market Price
The NAV is the value of the total portfolio held by a CEF and divided by the number of outstanding shares. In theory this would mean that the market price for a share of a CEF should be very close to its NAV.
Advantages of CEFs
Higher Yields Possible
Because CEFs can leverage borrowed money to invest in income producing assets the yields on the same can be higher compared to open end funds and which are restricted from using leverage.
Active Management
The investment portfolio of a CEF is actively managed by professional investment managers who pick and choose holdings and enact strategic decisions to enhance the fund’s performance and thereby hopefully outperforming passively managed index funds.
Discount to NAV
Unlike mutual funds which are always sold at NAV and CEFs can trade at a discount.
Cons of CEFs
Liquidity Risk
While open end funds are redeemed at NAV with no liquidity risk and closed ends are traded on exchanges and thus holding the potential for liquidity risks you may not be able to sell your shares right away for the price you want.
Management Fees
Most CEFs charge more than open end mutual funds and for the fees include management expenses and possible leverage costs. All these eat into your returns.
Discount Risk
The discount to the NAV fluctuates with market sentiment. If it widens and you could incur losses when you sell your shares.
Who Should Consider CEFs?
CEFs can be an appropriate choice for investors who are looking to
Higher Income Potential
Some CEFs’ leverage can be attractive to income focused investors seeking bigger yields.
Active Management Expertise
Any investor who believes in active management that one can outperform the market will love CEFs.
Potential Value Plays
If an investor is aware of the discounts to NAV concept he can and at times and exploit these situations to get assets cheap.
Keep in mind
Never venture into a CEF without careful assessment of your investment goals and risk tolerance and investment horizon. Conduct in depth research into the specific CEFs and including the objective of the investment and fees and usage of leverage and past performance.
Advantages versus Disadvantages ?
Closed End Funds provide a different type of investment vehicle versus their open end mutual fund cousins. Each raises a fixed amount of capital through an IPO and has a fixed number of shares trading on the exchanges. Therein lies some potential benefits and drawbacks for investors within the structure. Let’s further discuss the pros and cons of CEFs to help you determine whether they might fit your investment plan.
Advantages of CEFs
Higher Yields Possible
While open end funds are not allowed the use of borrowed money and CEFs can and much like REITs and participate in income producing assets with the use of borrowed money to amplify their yield. For instance the CEF may invest in high dividend stocks or corporate bonds and and through leverage and magnify the yield from the income producers.
Active Management
Professional investment managers guide CEFs and underpinning security selection and other strategic decisions in an active management process. This could deliver better than benchmark performance and quite unlike passively managed index funds and especially in volatile markets where astute selection might get better returns.
Discount to NAV
Probably the most appealing feature of CEFs is the chance to buy their shares at a discount to their net asset value. The NAV is the total value held by the CEF in terms of assets and divided by outstanding shares. If the market price for a share of a CEF is trading below its NAV and it then gives an opportunity to buy the assets at less than their value. Or and in other words and this discount could come out of market sentiment or the particular investment strategy taken by the CEF.
Lower Operating Expenses
Since CEFs do not need to maintain substantial cash to meet redemption demand from investors and their operating expenses can be lower compared to open end funds. Again and this translates to potentially higher returns for investors.
Disadvantages of CEFs
Liquidity Risk
While open end funds come with the assurance of redemption at NAV and closed end funds are listed on exchanges. This brings along liquidity risks. You may not be able to sell your shares immediately at the price that you would want and more so if it is not a very heavily traded CEF.
Management Fees
Generally CEFs charge more compared to open end mutual funds. These fees cover the management expenses and possible leverage costs and and other operational needs The higher fees can eat into your returns if the CEF doesn’t outperform the market by a significant margin.
Discount Risk
While having a discount to NAV can be an advantage and it comes with its own risk. If you sell when the discount is wider than when you bought and you may incur losses.
Complexity
CEFs can be expected to be more complex to understand than the more traditional mutual funds. Variables like leverage usage and the impact of discounts to NAV require more research and analysis for investors.
While providing a special blend of potential benefits and drawbacks to the investors and CEFs offer an even greater temptation to yield and active management expertise and value plays through possible discounts to the NAV. On the other hand there is increased complexity and liquidity risk and the potential for wider discounts and all things that require caution.
This and of course depends upon your personal investment goals and your level of risk tolerance and and your investment time horizon. For a long term investor who puts a premium on the generation of income and active management the CEF can provide an attractive attribute base within an investment portfolio. On the other hand open ended mutual funds should be considered for one who has liquidity and low fees at the top of their priority list.
Key Factors When Choosing
The wide world of closed end funds offers many investment options but each of these funds needs to be picked over carefully. Unlike open end mutual funds with their one size fits all approach and CEFs come in varied flavors and each carrying its unique risk reward profile. Here are the key factors to consider before any investment decision in a CEF
Investment Objective
Income Generation
If you want steady income and consider only those CEFs that invest in high yielding assets and which may include corporate bonds and municipal bonds and or real estate investment trusts.
Capital Appreciation
If what the investor wants is long term capital growth and CEFs concentrated in equity or growth stocks may be more appropriate.
Total Return
If you want to find a balance between income and capital appreciation and CEFs invested in a mix of asset classes are what you need to consider. In such cases a diversified balanced CEF will help an investor ride through market ups and downs.
Expense Ratio
CEFs collect fees from investors to cover management expenses and possible leverage costs and among other operational requirements. In this instance the fees translate into an expense ratio. The lower the expense ratio and the larger the chunk of your investment goes toward returns. Other CEFs may have better yields on their shares but their expense ratios might badly corrode those gains.
Leverage Usage
Some CEFs use leverage meaning that they borrow money to invest and amplify their returns.Be careful about the degree to which a CEF is using leverage. The more leverage used and the greater the risk and especially during times of greater market volatility.
Distribution History
Income oriented investors should have a very important issue how safe is the distribution history of a CEF. Check the sustainability and consistency of its distributions. Check the source of the distributions capital gains or income from holdings and how this fits within the investment objective of the fund.
Underlying Holdings
It’s not just the headline features that get into the nitty gritty details of the specific assets held by a CEF.
Remember
A CEF investment is a detailed process. It makes it possible for you to sail in the world of CEFs with needed clarity on the risks and rewards involved.
Different Kinds of Closed End Funds
The universe of closed end funds runs the gamut of investment opportunities and all tailored to address the goals of different investors. While open end mutual funds are mostly broadly diversified and closed end funds often focus on a specific asset class and sector and or investment strategy.
Below are some of the most common types of CEFs
Municipal Bond CEFs
CEF funds invested in bonds issued by state and local governments are mostly municipal. Generally and municipal bonds would have tax free income from the federal standpoint and while state and local taxes may or may not be exempted and depending on where one resides. Such funds offer better options to income investors who focus on getting tax advantaged returns.
High Yield CEFs
These CEFs deal with high yield bonds and are also called junk bonds. Bonds rated in this category have the potential to have higher yields than investment grade bonds. In return and of course they carry a higher risk of default. The high yield CEFs provide an opportunity for investors seeking a higher risk profile against higher income payouts.
Equity CEFs
These CEFs primarily invest in equities. Equity CEFs can be an excellent means of exposure to certain sectors or asset classes and for example technology stocks and healthcare stocks and or emerging markets equities. How much risk an equity CEF holds will depend on the underlying holdings and the sector it focuses on.
Mortgage REIT CEFs
These CEFs invest in mortgage real estate investment trusts. A mortgage REIT CEF is one way through which one can indirectly invest in real estate and earn regular dividend distributions.
Specialty CEFs
This category is a broad representation of CEFs that have implemented specific investment strategies. Some examples include
Fund of Funds CEF
Such CEFs are invested in a basket of other CEFs and which thereby offers diversification across many strategies and asset classes.
Activist CEFs
These funds specialize in the investment of companies in which the manager believes they have the potential to make a positive difference through shareholder activism.
Merger Arbitrage CEFs
These CEFs strive to profit on price discrepancies between companies involved in mergers and acquisitions. How to Choose a CEF Type
The type of CEF most suitable for any investor is the one that dovetails into the investment goals and risk tolerance.
Income focused investors
All municipal bonds and high yield and mortgage REIT CEFs are good for generating regular streams of income.
Growth oriented investors
Certain sector CEFs within the equity category offer very good growth potential and can be leveraged into capital appreciation.
Risk averse investors
Start with CEFs invested in low risk assets like investment grade bonds or those that hold diversified balanced holdings.
It’s important to research any particular CEF within each type. As such you need to consider the details of the underlying holdings and fees and use of leverage and managerial record prior to investing in any particular fund.
Navigating the Landscape
The closed end fund (CEF) world is a synthesis of the major reasons for and against them. While they are able to offer access to such specialized strategies and active management and probably higher yields they are fraught with features like liquidity risk and complexity. Implementing best practices in CEFs will help set you up for the most success. These best practices include
Do Your Homework
Before getting into any CEF and proper research is essential. Some of the key aspects to examine are
Investment Objective
First and be very clear about your personal investment goals. Are you interested in income and capital appreciation and or is one of the two more important? Choose a CEF whose objective matches your needs.
Discount to NAV
Understand the current discount that the CEF is trading at to its NAV. While a discount can be beneficial and extremely large discounts may be indicative of underlying problems.
The expense ratio
The lower and the better and as more of your money goes toward returns. Compare the expense ratio of the CEF with that of similar offerings.
Leverage usage
Understand how much leverage is being used by the CEF. The higher the leverage and the more potential gains or losses it can realize.
Management track record
Check the experience and track record of the management team of the CEF. Try to find managers with a record of consistency in strategies similar to their current one.
Distribution History
For income focused investors and check the distribution history of the CEF. Check for consistency and sustainability of distributions and the source of the distributions and such as from capital gains or income from the holdings.
Liquidity
Check the average daily trading volume for the CEF. Lower liquidity can make buying or selling a number of shares difficult at a quick pace and at your chosen price.
Underlying Holdings
Never get too caught up with headline features. Instead and focus on the actual assets held within the CEF to truly grasp the fund’s overall risk profile.
Discount to NAV
One of the key benefits of CEFs is the opportunity to invest in shares at a discount to NAV. However don’t blindly chase extremely large discounts. You need to research why there is such a discount and make sure it doesn’t indicate some inherent problem with the fund or its holdings.
Long term focus
The CEFs are more volatile and being sector or strategy exposed than open end mutual funds. Be prepared to hold the investment for the long term to ride out market fluctuations and maximize your potential returns.
Monitor Your Investments Regularly
Do not set and forget your CEF investments. Follow their performance regularly and news related to the fund or its holdings and any changes in the discount to NAV.
Seek Professional Advice (Optional)
If you are overwhelmed by all the intricacies of a CEF you may want to consult an investment advisor. An advisor can assist you in determining your investment objectives and risk tolerance and then recommend CEFs that best fit your needs.
Provided you apply these best practices and do some careful research and you can benefit from the one of a kind advantages of CEFs while being very aware of the potential pitfalls.
Conclusion
The world of closed end funds presents an interesting alternative to traditional mutual funds. With the potential for higher yields and active management expertise and the opportunity to pick up assets at a discount CEFs can make up a seminal component of a broadly diversified portfolio. But this is not without careful deliberation. Appreciate the pros and cons and key parameters to consider and best practices for investing in CEFs and then make an informed decision. Detailed research and a long term perspective and a diversified approach certainly are some of the cardinal rules mitigating risk for any kind of investment. So set sail on your CEF investment journey with greater confidence and armed with both keen eyesight and a steady hand.
