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Crack Open Closed-End Funds to Avoid the Relevance Paradox

Follow these rules to avoid CEF disappointment.

Mike Taggart, 10/10/2011

Income-seeking investors have long known the attraction of closed-end funds. With their use of leverage, income-oriented investment strategies, and ability to make regular distributions, most closed-end funds were built to deliver payment streams.

But all too often, investors don't get the results they were expecting. Simply put, some investors--largely unfamiliar with closed-end funds--do not understand what they've invested in until it's too late. Having reached a poor outcome, they conclude that the allure of closed-end funds isn't worth what appear to be hidden risks. It's a symptom of the relevance paradox.

This paradox arises because, for any given issue, we only gather information that we believe is relevant. If you believe that closed-end funds are just like stocks (after all, they trade on an exchange just like stocks), you will apply your stock-assessing methodology to closed-end funds and reach a largely uninformed conclusion.

The same result will occur if you treat closed-end funds as bonds or traditional open-end mutual funds. The relevance paradox, then, causes investors to make the wrong--or at best a shaky--conclusion about the quality of the closed-end fund they are investing in.

For income-oriented investors, this can lead to real headaches. Unaware that their closed-end fund's income payments include a component of return of capital (in some limited cases), investors get frustrated when their total return declines and their payment gets cut. Unaware that their fund produces high income primarily through heavy use of leverage (in many cases), they are shocked by the volatility of their returns. Concluding that closed-end funds are just too risky and complex, they sell positions at a loss and forswear future use of the investment vehicle.

In fact, closed-end funds are a great investment vehicle for income-seeking investors. Among funds that distribute payments more often than annually, the average distribution rate at the closed-end fund's share price is 7%, without taking into consideration the underlying asset class.

Knowing what questions to ask before purchasing a closed-end fund can set investors on a path toward a positive investment outcome. Of course, nothing is ever guaranteed. But following a few rules and understanding the typical mistakes closed-end-fund investors often make can make for a less stressful investment experience.

Rule 1: Stay Focused on Total Return
Closed-end-fund investors get the share-price total return, but it's important to keep an eye on the net-asset-value total return because it shows how successful a manager has been with his or her portfolio.

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