Closed-End Funds: Smart Investment, Smart Returns

Closed-end funds (CEFs) are a type of mutual fund where investors pool their money and a professional money management team oversees the portfolio by selecting the underlying stocks, bonds, and other securities. CEFs are traded like stocks rather than bought from the fund company like the better-known open-ended funds. CEFs are ideal for investors seeking predictable income potential, diversification, and flexibility. They are also attractive to investors due to their large distribution yields and the ability to purchase the fund at a discount to the net asset value. However, CEFs are less liquid and more volatile than open-ended funds, and investors need to be cautious about the risks associated with leverage.

High dividend yields

Closed-end funds (CEFs) are an attractive option for investors seeking high dividend yields. CEFs offer dividend yields that are significantly higher than those of typical S&P 500 stocks or Treasury bonds. Yields of 7%, 9%, or even 11% are not uncommon for CEFs, providing an appealing income stream for investors, especially in the current low-interest-rate environment.

The high dividend yields of CEFs are made possible by their unique structure. Unlike open-ended funds, CEFs have a fixed number of shares that are traded on the stock exchange. This means that the share price of a CEF can diverge significantly from its net asset value (NAV), trading either at a premium or a discount. CEFs often trade at a discount to their NAV, which allows investors to buy high-quality investments, such as shares of Apple, Microsoft, or Berkshire Hathaway, at a lower price than their market value.

Additionally, CEFs pass through a large portion of their capital gains and investment income as cash dividends. The high dividend yields of CEFs are further enhanced by the fact that they often trade at a discount to their NAV. This allows CEF managers to sustain attractive dividend payouts to investors even if the fund's income stream is lower than the dividend yield. For example, if a CEF is trading at a 10% discount and has a dividend yield of 8%, the fund managers only need to achieve a 7.2% income stream to cover the dividend payouts.

The combination of trading at a discount and high dividend yields makes CEFs particularly appealing to income-oriented investors. CEFs are also beneficial for investors who want to invest in specific types of assets, such as real estate investment trusts (REITs), corporate bonds, municipal bonds, US stocks, or foreign investments.

However, it is important to note that CEFs come with certain risks. They can have high management fees, use leverage, and employ complex investment strategies that may increase risk. Additionally, CEFs may have liquidity issues, as they trade like stocks, and investors need to find a willing buyer when they want to sell their shares.

Ability to buy high-quality investments at a discount

The ability to buy high-quality investments at a discount is a significant advantage of closed-end funds (CEFs). CEFs often trade at a discount to their net asset value (NAV), which is the fund's per-share value calculated by subtracting liabilities from the total value of its underlying assets. This discount allows investors to purchase shares in companies like Apple, Berkshire Hathaway, Microsoft, and Wal-Mart at prices lower than their market value.

The reason CEFs frequently trade at a discount relates to the basic economic principles of supply and demand. Unlike open-end mutual funds, CEFs have a fixed number of shares outstanding after their initial public offering (IPO). This fixed supply means that the price of CEF shares in the secondary market is determined by investor demand rather than the underlying value of the fund's assets. High demand for CEF shares can lead to a premium (price above NAV), while low demand can result in a discount (price below NAV).

The CEF structure, with its fixed number of shares, also gives shareholders more power over whether to allow new capital into the fund. If existing shareholders are unwilling to sell their shares to a new investor, the new investor may need to offer a higher price to create an incentive for shareholders to sell. This dynamic can further contribute to CEF shares trading at a discount.

The discount offered by CEFs provides an opportunity for investors to buy high-quality investments at a lower price. However, it is important to carefully analyse the reasons behind the discount, such as fund management quality, investment strategy, and market conditions, before investing.

Steady income potential

Regular Distributions

CEFs are specifically structured to provide consistent and predictable income to investors. They are designed to translate their total returns into regular distributions, often on a monthly or quarterly basis. This steady income stream makes CEFs appealing to investors seeking regular cash flows.

High Dividend Yields

CEFs often offer significantly higher dividend yields compared to other investment options. While typical S&P 500 stocks may provide low dividend yields, CEFs can offer yields of 7%, 9%, or even higher. This makes CEFs an attractive option for income-oriented investors.

Leverage and Enhanced Returns

CEFs commonly employ leverage to boost their investment returns. By borrowing money or issuing debt, CEFs can increase their purchasing power and invest in additional assets. This leverage can lead to higher income distributions and potentially higher returns for investors. Over 70% of US CEFs use leverage to enhance their income distributions.

Actively Managed Distributions

CEFs are actively managed by professional fund managers who focus on maximising distributions. They aim to smooth income streams and manage distributions to provide consistent payouts to investors. This active management approach helps ensure a steady and predictable income for CEF investors.

Discounted Purchases and Premiums

CEFs trade on stock exchanges, and their share prices can fluctuate around their net asset value (NAV). Sometimes, CEF shares trade at a discount, providing investors with an opportunity to buy CEF shares at a bargain price. This allows investors to acquire a larger number of shares and potentially benefit from higher dividend payouts. Conversely, CEFs can also trade at a premium, where the market price exceeds the NAV.

Access to Less Liquid Markets

CEFs can provide investors with access to specialised and less liquid corners of the market that may be difficult to access through other investment vehicles. This includes alternative securities, real estate, and private placements. While these types of securities may pose higher risks, they offer diversification and the potential for enhanced income.

Greater control over buying and selling

Closed-end funds (CEFs) are traded like stocks, meaning they can be bought and sold at the market price anytime during the trading day. This is in contrast to open-ended funds, where you can only buy or sell at the net asset value (NAV) calculated after the market closes. This makes CEFs more nimble, allowing investors to get in quickly if the market spikes and out if it drops.

The share price of CEFs is set by supply and demand, meaning that CEF shareholders have a lot of power over whether to allow new capital into the fund or not. This is because CEFs have a fixed number of shares, so if a new investor wants to put money into the fund, existing CEF shareholders need to sell their portion of the assets to the new investor. This can lead to a situation where the new investor has to incentivise existing shareholders to sell by offering a higher price, which can drive up the share price.

However, it's important to note that the CEF owner who wants to sell their shares may not find a buyer, and will have to wait until there is one. This is a key difference from open-ended funds, where the fund company must accept your redemption whenever you want. This can make CEFs harder to sell in a market freefall, as there may be a lack of buyers.

Another factor to consider is that CEFs are traded on the secondary market, meaning that investors pay a broker's commission for every trade. This can add up for investors who have a set amount invested every month.

Overall, CEFs offer greater control over buying and selling compared to open-ended funds, but this comes with the trade-off of potentially reduced liquidity.

Employ leverage to boost income

Leverage is a strategy used by many closed-end funds (CEFs) to boost income and returns. Leverage is when a fund borrows capital through debt issuance or preferred share issuance, or by using financial products to increase the value of its underlying portfolio. This gives the fund manager more capital to invest in more securities that produce income for the fund.

The use of leverage is particularly well-suited to the CEF structure. CEFs have a fixed number of shares created at the start and traded on the stock exchange. This means they have a steadier asset base compared to open-ended funds, which can more easily maintain the ratio of a fund's leverage to its total assets.

Leverage magnifies portfolio performance, whether positive or negative. If the underlying portfolio return is positive, a leveraged fund will typically have higher returns than an unleveraged fund with the same portfolio. Conversely, if the underlying portfolio return is negative, a leveraged fund will have greater losses than an unleveraged fund.

Leverage can also lead to higher distribution rates. The underlying yield of a portfolio can be magnified through leveraged assets.

However, it's important to note that leverage also increases the volatility of a fund's net asset value (NAV) and potentially increases the volatility of its distributions and market price. It can also lead to higher costs, as payments must be made to the providers of the leverage.

Despite the risks, industry studies show that over a long period, the benefits of leverage in CEFs outweigh the drawbacks.

Frequently asked questions