Closed-end funds (CEFs) can play an important role in a diversified investment portfolio. They offer benefits similar to those of an open-end mutual fund, but also sport unique advantages.
Unlike a traditional open-end mutual fund, CEFs have a fixed number of shares available to trade. Their price is not tied to the value of the underlying portfolio. The only way the number of shares can change is by increasing shares through a rights offering or decreasing shares in a tender offer or repurchase program.
CEFs offer many of the same benefits common to open-end mutual funds such as diversification, income distributions, and professional management. Both types of funds may distribute interest, dividends, and capital gains. Both structures provide the opportunity to invest in more specialized sectors with risk distributed across a professionally managed portfolio of securities.
There are also many distinguishing features of a CEF that provide advantages not provided by a mutual fund.
Buying at a Discount: Often CEFs trade at a discount or premium to the NAV because the CEF’s share price is driven by supply and demand. For funds trading at a discount, this offers the potential to boost investment returns.
Discount to NAV narrows. If the discount to NAV closes or narrows, an investor can realize enhanced performance. The performance measure includes the income earned on the fund, the appreciation or decline in the NAV and then also any change in the gap between market price and the NAV.
Provides a higher yield / return: Because you are buying more than a dollar’s worth of assets for every dollar invested, the yield/return on actual dollars invested will be higher.
Efficient Portfolio Management: Because a CEF is made up of a stable pool of capital, a manager isn’t concerned about the continuous cash outflows and inflows that can disrupt a traditional mutual fund manager’s strategy. He will not have to sell securities to meet investor requests to redeem shares, nor will he be forced to purchase securities when investment demand increases and new cash comes in to the fund. The manager can focus clearly on the fund’s objectives and invest with a long term strategy.
Advantage in Specialized or Less Liquid Markets: CEFs have an advantage when investing in specialized or less liquid asset classes or single country markets. Due to the stable nature of the fund’s structure, they can maintain a long term outlook and withstand price volatility in less liquid markets.
Leverage potential: Often a CEF will use leverage to enhance performance. CEFs can borrow at short term rates by issuing senior securities in the form of debt or preferred stock. This approach offers the potential to increase yield and offer higher levels of income than a traditional open-end fund.
Exchange traded: A CEF trades like a stock on the exchange and can be bought and sold at any time during the day. An investor can also place limit orders to have complete control over the price paid for a fund.
Types of CEFs
The largest category, in terms of assets under management, is tax-exempt bond funds. These funds invest in tax-free bonds issued by state and local governments and agencies. Many of them use leverage to increase the fund’s returns.
Domestic taxable bond funds are also available and dedicated to a variety of bond issuers such as treasuries, corporate bonds, and agencies. Domestic equity funds include a broad mix of stocks and can be focused on a particular sector or a strategy like growth or income. Global and International CEFs can be focused on a single country or a less liquid sector such as emerging markets. A CEF is advantageous in these cases because the fund has the ability to hold in volatile markets or periods of market decline.
When looking at CEF investment performance, focus on the total return. Capture the rise or decline in the market price taking into account any change in the discount or premium as well as the income from fund distributions. Always prefer CEFs trading at a discount, and avoid or sell those trading at a premium.
Note: Donna St.Amant, MBA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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