Closed End Funds Primer

Intro: This Closed End Fund Primer is intended as a basic overview to explain in a simple manner and demystify these lesser known investments. These funds in my opinion are NOT for new investors due to their inherent construction.If you do not know what these Closed End Funds are about you will find some valuable information to their basics in this article; and some general unvarnished pros and cons.

Overview of Closed End Funds

What are closed end funds? These funds trade all day long on the exchanges just like stocks. Closed End Funds are sort of like Open Ended mutual funds except that their shares can trade or “float” at times in deep discounts or large premiums to their Net Asset Value (NAV). Open End funds only have an end of day NAV price. CEF's are beholden to the market forces of supply and demand. Not it's NAV. This is because after a fund opens with an IPO, closed end funds trade with a fixed number of shares on the secondary market that represent the portfolio.When an investor buys (sells) an open-end fund, that fund manager must buy (sell) more securities in the portfolio.Not so for closed end funds.Its actual NAV may be 10 or 15% higher or lower than (or near) actual portfolio NAV. Again, CEF’s trade on all the major exchanges all trading day just as like a regular stock.Open-end funds have a set price that changes just once a day. CEF’s are actively managed and consist of a wide variety of choices. Their portfolios invest in almost every asset class, sector and global region.These fund types can include municipal bonds funds from specific states( a very large niche), including insured, intermediate, long term etc. Domestic (U.S.) government, mortgage, international and even emerging market bond funds.Equity stock type CEF's may have portfolios with exposure to international, domestic, sector specific, emerging market, equity income, etc.Also, CEF's are available that invest in preferred shares, convertibles, corporate bonds, and REITS (Real Estate Investment Trusts).Barron’s publishes each week a “Weekly Closed End Fund” roundup of all closed end finds and their NAV’s market price and yield and 52 week return.This can give you a quick glance at the many closed end funds available and their premium/discounts.

Dividends?

Closed end funds pay “dividends” to their shareholders in several forms.They can be ordinary dividends, interest income, and capital gains dividends. Some funds may appear to have an unusually large dividend when in fact it is partially a return of capital to the shareholder.This is called a “managed distribution policy”.They do this for a more predictable monthly or quarterly payout, which may be desirable to some shareholders looking for more steady income yield.These unusual high yielding funds may often times be driven by shareholders to trade at a premium to NAV.

More Anomalies

One drawback of investing in closed end funds can be the lack of liquidity.Some funds are thinly traded and may have wide bid/ask spreads.I remember a couple of years ago I attempted to buy a closed end fund with a limit order and the specialist would move the ask up as I tried to buy.He moved it up again when I resubmitted my order.Argghhh!!!. I ended up canceling the order and not buying the fund.Anyway, it is always wise to use limit orders and perhaps accumulate a position rather than a large purchase in one trade.Because of this lack of liquidity in a slow market, these funds will be more volatile than a similar open-end fund.This unusual price action can be very common for closed end funds. It also key to always know the NAV of a fund and its premium to discount range over time before investing.Just because a fund is trading at a 10 percent discount does not mean it can not spread to even a 15 or 20 percent discount in the future.Also, another caution; never buy an IPO for a closed end fund.They always go to a discount several months after their IPO.Their underwriters will sell their shares after the lockup period expires, driving the shares to a discount. Another reason Closed End funds can be more volatile is that some funds use of leverage.This use of leverage can magnify the returns but can add to the risk of a closed end portfolio.The use of leverage may have some fund mangers to use the auction rate security market. Depending on interest rates and the credit markets this can cause some funds to be prone to market shocks like we have had recently with the market meltdown and credit tightening. Managers may have had to reduce their credit exposure.

Explaining the Simple Strategies for CEF's

Is a Buying a CEF at a Large Discount to NAV always a “Free Lunch”? Burton G. Malkiel in various editions of “A Random Walk Down Wall Street” has recommended buying closed end funds selling at large discounts with the simple idea that you can buy $100 worth of assets for $80. Related studies by financial academia have also concluded that you can earn these abnormal returns by buying a closed end fund shares at discounts and simply selling when they reach a premium or the discount narrows. Not surprisingly, these works have also found that the larger the discount, the bigger the abnormal returns. It will be interesting in the years to come if this research holds up because of the relatively recent proliferation of Exchange Traded Funds, (ETF'S). The ETF's are probably siphoning at least some of the potential CEF industry's asset's. This notion would be a good candidate for investigation.

Buyer Beware?

My own non-scientific research and experience concludes that those funds with huge discounts over time are not good investments. Those types of CEF's always have a large discount for a reason(s). It's best to stay away from those investments and getting trapped with a fund that's essentially "dead money". Some of the websites I list provide historical fund premium/discount data over long periods of time. This is extremely useful information because you can see not only the premium and discount; you may also see what the NAV is doing over time and gauge the funds management and holdings accordingly. I might also point out that during a brief market stress, a CEF may quickly dip to a large discount; but the better more desirable funds will bounce back rather quickly.

Arbitrage & the Closing Discounted CEF

Another strategy employed to create abnormal returns using closed end funds is the buying of funds that are at discounts that are about to become open ended.This may happen when an activist shareholder demands that the fund becomes open-ended because of the constant discount.This can entail costly legal and/or proxy battles but can be fruitful for the investor in these closed end funds.At the conclusion of this conversion, the fund will commence trading as an open-end fund at NAV, thereby eliminating the discount rapidly and creating gains for the shareholders who were along for the ride.Several years ago I owned a closed end fund (symbol FVI) which was a First Trust fund.This fund’s NAV over time was performing nicely but it persistently had a 10 to 15 percent discount.It was eventually converted to an exchange traded fund with very little spread between NAV and market price. The advisors, First Trust presumably did this perhaps to avoid a costly battle that was brewing between some of its funds and an activist shareholder group.

An Unvarnished Summary with Some Pros and Cons:

Pros

• CEF's can provide some "outsized" market gains" over time.
• Sometimes, if careful, quick and a bit lucky - you can actually get $100 worth of assets for $80. I don't include the "dead money" permanent discount funds.
• Your heavily discounted Fund may be taken over and/or influenced by a large activist investor who wants to convert the fund to Open staus or an ETF - and thereby destroying the discount.
• Provide needed income to retirees via the vast selection of Muni Bond funds or other income yielding funds. These Muni Funds are a very large and respected niche.

Cons

• Very Exspensive. Most Closed End Funds have very high Exspense Ratios that far exceed the typical ETF. Many Closed End Funds may have management fees of 1.5%, 2%, or more. The typical ETF is well below 1%. These fees add up as John Bogle of Vanguard has told us for many years.
• Many have very low volume thereby making them potentially volatile. Only use limit orders, nobody like surprises. CEF's can be just as volatile as a leveraged ETF under stressed market conditions. Fasten your seatbelt.
• Require much more research and homework than most ETF's. Most ETF's are indexed based with their holdings readily available. Be careful and do some due diligence.

• Interest rate risk; income ETF's are prone to potetenial volatiliy if rates start rising.

  

  Conclusion

  If you must venture into the wily world of Closed End Funds, be very careful, do your DD. Monitor any news of your fund,be aware of the historical and the current premium or discount to NAV. If you do not want all of this fuss, then you may consider ETF's instead; and I woud not blame you a bit. -Good Luck in all of your Investing forays-

Helpful Closed End Fund Links

Several informative websites for CEF’s performance, amount of leverage, research, data, and sorting include:

www.cefa.com/

www.morningstar.com/

online.wsj.com/mdc/public/page/2_3040-CEFmain.html?mod=mdc_h_mfhl www.bloomberg.com/apps/data?pid=invest_mutualfunds

www.cefconnect.com/