The Lowdown on Closed-End Funds (CEFs)
You probably own shares of a few mutual funds. Maybe you also have some shares of an exchange-traded fund (ETF) or two. But what about closed-end funds? Got any of those?
A lot of investors haven’t even heard of closed-end funds (CEFs), but they’re actually the oldest type of fund, predating open-end (i.e. “regular”) mutual funds and ETFs by decades. They can also be extremely lucrative income investments — if you know what you’re doing.
The average CEF yields 6.38% a year at the time of writing, many yield more than 10%, and some yield more than 20%. But as you might imagine, there’s a reason those yields are so high.
CEFs have some complicated inner workings, and investors who don’t understand those workings can easily get burned. Today, we’re going over the basics of closed-end fund investing so you can collect those double-digit yields with confidence.
Let’s start with a simple definition...
What Is a Closed-End Fund (CEF)?
A closed-end fund is a type of mutual fund that has a fixed number of shares, is actively managed, pays out lots of dividends and capital gains distributions, and trades in real time on a stock exchange.
“But wait,” you might say. “Isn’t that basically the same thing as a regular mutual fund or ETF?”
Yes, it’s basically the same thing — but not entirely the same thing. There are a few differences between these types of funds that might seem small but have a large impact on how investors should use them.
Unlike mutual funds and ETFs, CEFs only issue shares and raise capital once. They conduct initial public offerings (IPOs) just like individual stocks. After that, the fund is closed to new capital, hence the name.
ETFs and open-end mutual funds can issue and redeem shares to meet investor demand. These mechanisms keep the share prices of these funds consistent with the values of the securities they hold (their net asset values, or NAVs).
But since a CEF can’t do those things, its share price fluctuates in real time based on supply and demand, and although it generally tracks the fund’s NAV, it isn’t necessarily equal to it. Some CEFs trade at a discount to NAV, others at a premium. And investors can earn a profit by buying a CEF at a discount and selling it at a premium, even if its NAV doesn’t change.
Unlike ETFs and many mutual funds, CEFs also tend to be actively managed. And their managers tend to have a focus on income.
Many CEFs are heavily invested in bonds and dividend stocks, and they pay those dividends directly to shareholders. They also pay out capital gains distributions whenever they sell securities at a profit.
The frequent payments made by CEFs to shareholders keep their NAVs relatively stable. They also create the extremely high yields that attract income investors.
The table below shows the various differences between these three types of funds.
In summary, CEFs are complex investment products that can be very powerful income generators for investors who know how to use them.
So how do you use them?
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Dos and Don’ts of Investing in Closed-End Funds (CEFs)
Let’s start by listing what not to do when shopping for a CEF:
Buying a CEF that is trading at a premium to NAV isn’t a great idea. Most CEFs trade at discounts; a premium can indicate overvaluation. A higher price can also push down the yield that you are effectively earning on your investment.
On a related note, it’s inadvisable to buy a CEF fresh from its IPO. Many CEFs go public at a premium to their NAV, and that premium often turns into a discount as the IPO hype fades.
Finally, given the large and frequent distributions made by CEFs, you shouldn't hold them in a regular taxable brokerage account. Doing so could land you a big income tax bill next April.
And now let’s list what you should do when shopping for a CEF:
Look for a fund that is trading at a discount to its NAV. Ideally, you want a fund that is trading at a bigger discount to NAV than its one-year average discount. This information is easily accessible on websites like Morningstar.
Make sure any CEF you consider buying has at least five years of solid performance, preferably under the current fund manager.
Look for a CEF with an expense ratio around or below 1% to minimize costs, and hold the fund in a tax-advantaged account to minimize taxes.
If you follow this simple list of dos and don’ts, then you’re ready to take advantage of an obscure but lucrative class of funds — one that boasts higher yields than just about anything else on the market.
Until next time,
Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.
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