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Morningstar’s Top Tips For Investing in CEFs

Investors willing to take the time to learn the ins and outs of CEFs will discover a relatively unfollowed and often mispriced slice of the market.

Jason Kephart, 08/11/2016

Many investors aren't familiar with closed-end funds, or CEFs. Some investors who are somewhat familiar with CEFs may view them as overly complex, believe they're difficult to use, or dismiss them with a "those things are just wacky" type of comment. While it is true that CEFs are structurally more complex than exchange-traded funds and open-end mutual funds, investors willing to take the time to learn the ins and outs of CEFs will discover a relatively unfollowed and often mispriced slice of the market. Whether you're new to CEFs or an old pro, here are some of our best tips to make investing in CEFs a better experience. The following are excerpts from Morningstar's Guide to Closed-End Funds, which is available to subscribers of Morningstar Direct. 

Just Say No at the IPO
It is often said that CEF IPOs are sold, not bought. At Morningstar, we believe that most investors should avoid purchasing shares of a CEF at the IPO, mainly because of the "CEF IPO Premium" phenomenon caused by the high commissions paid to brokers for selling shares and the absence of a fiduciary standard applied to those brokers.

From a nuts-and-bolts perspective, launching a new fund isn't free--there are legal, filing, and underwriting fees, and investors have traditionally been on the hook for those fees. Mathematically, this means that all CEFs trade at premiums at the IPO. Exhibit 1 shows a hypothetical CEF IPO. For simplicity, assume the CEF sells a single share, which means the fund's manager starts with $25 (the price of one share). After paying underwriting and other fees ($1.19 in this example), the manager has $23.81 to invest according to the fund's strategy. This investor just paid $25 for $23.81 worth of assets and has experienced the "CEF IPO Premium" phenomenon firsthand. Premiums aren't necessarily bad, but IPO premiums tend to dissipate within a few months of a fund's launch, generally leading to a loss for shareholders who purchased shares at the IPO.

Source: Morningstar.

Participating in Rights Offerings Is a Must
Rights offerings allow existing shareholders to buy a proportional number of shares, based on how many they currently own, at a discounted price. Rights can be both transferable (meaning they can be traded on an exchange) and nontransferable. Shareholders have the right, but never the obligation, to buy the additional shares. If an investor likes the fund and wants to allocate more capital to it, exercising a rights offering is a no-brainer--simply subscribe to the offering and purchase additional shares. But many investors will not wish to allocate more capital to the fund. By not participating, however, their stake in the fund is diluted. This is because additional shares are sold at a discount to market value, which increases the number of shares outstanding by more than the assets in the fund. Exhibit 2 illustrates the dilution.

Source: Morningstar.

Fund XYZ has two shareholders (A and B), and each owns three shares at $10 per share. Fund XYZ's total market value is $60. The fund implements a 1-for-3 rights offering (allowing each shareholder to purchase one additional share) at 90% of the market price of $10. Shareholder A participates in the offering, purchasing an additional share for $9, but Shareholder B does not participate.

is an analyst covering alternative strategies on Morningstar’s manager research team.

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