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Consider Adding Closed-End Funds to Your Investment Arsenal

Expand your menu of options beyond mutual funds and reap the benefits.

Mike Taggart, CFA, 02/10/2012

Having more options is usually a good thing. Last spring, while on my honeymoon, my wife and I were in Boppard, Germany, a small town where the Rhine River bends itself into a "U" shape. The best view of the topography is from a spot on a mountain known as Gedeonseck. Getting up there, though, took some doing. The local restaurateur, who we befriended, suggested we spend the day taking the scenic hiking path, but we didn't want to spend the entire day getting to the destination. An athletic-looking gent at the next table suggested a bike path, but we had no bikes, and I'm not in that kind of shape. Eventually, by consulting a guidebook, we figured out on our own that there was a chairlift that could get us to the summit in 15 minutes. The problem was that I'm afraid of heights. The goal was to get to the top of the mountain, and I either had to get comfortable with the thought of dangling by a cable at high altitude or get over my desire to see the view.

When it comes to investing, I want to consider all of my options and determine for myself if I'm comfortable with the risks. If you're a mutual fund investor, I’m guessing you’re the same way. For instance, if you decide that you need more U.S. small-cap stock weighting in your portfolio, you probably consider looking at several mutual funds that offer that investment strategy. But are you considering other types of funds--other investment vehicles--pursuing the same strategy? As for me, if I want more of my portfolio weighted toward U.S. small-cap stocks, I could care less whether I get that additional exposure from a mutual fund, a closed-end fund, or an exchange-traded fund. I really just want to choose the investment that I believe will meet my investment objective, which is to increase my net worth. By adding closed-end funds, or CEFs, to your investment arsenal, you can expand your menu of options when it comes to security selection.

Someone recently asked me, "Closed-end funds are sophisticated investments, right?" I quickly realized that my questioner unwittingly pinpointed what is perhaps the primary issue keeping most investors from considering CEFs: They seem more complex than mutual funds. But I don't believe that's the case. CEFs are not highly sophisticated, modern-day hocus-pocus. If you are already successfully investing via mutual funds, I am confident that with a little reading, a few rules of thumb, and some familiarity, you would quickly become comfortable with closed-end funds. In fact, we put together our CEF Solution Center to bring investors like you up to speed relatively quickly on important CEF topics. And, over time, you could become just as adept at spotting attractive CEFs as you are at finding good, solid mutual funds.

I am convinced that most mutual fund and equity investors can easily learn the rudimentary ins-and-outs of CEFs. Why do I think this? Because I'm willing to bet that CEF aficionados did not start out investing in CEFs. Given the relatively small pool of CEFs (629 today) available to investors, it is far more likely that the current CEF gurus cut their teeth investing elsewhere. Perhaps they were stock investors following a contrarian, value-oriented style, and they realized that CEFs often trade at discounts to their intrinsic value. Or perhaps they were mutual fund investors, fed up with loads and the once-daily buy-or-sell settlement times. Or they could have been income-seeking investors who became captivated with CEFs' leverage-enhanced "yields." In any event, over time they began considering CEFs alongside mutual funds and, later, ETFs, when it came time to tweak their portfolios.

Let's consider two reasons you may want to broaden your options: CEFs' discounts and distribution rates (also incorrectly called "yield" and "dividends") are probably the two largest reasons that people first consider a CEF for their portfolio.

Discounts
One of the compelling lures of CEFs is that they often trade at discounts to their net asset values. The "closed" in "closed-end funds" arises from the fact that these funds are largely closed to capital inflows and outflows. CEFs raise their capital in initial public offerings, similar to corporations. After the IPO, their shares trade on the stock exchange while the capital is invested in a portfolio of securities. This portfolio value is expressed, just like with mutual funds, as an NAV, per share. Meanwhile, the market dictates the share price. As a result, the share price and the NAV are rarely the same. When the share price is below the NAV, the shares are trading at a discount; and when the share price is above the NAV, the shares are trading at a premium. Discounts and premiums arise for many reasons. Those are the basics for discounts.

There are a few of rules of thumb to bear in mind about discounts and premiums when you're first starting out. First, discounts and premiums tend to persist. Do not purchase a CEF because you think you are getting a bargain because of the discount. I can't tell you how often I’ve seen the following headline on CEF articles: "Buy (insert name of a hot stock) at a 20% discount in XYZ fund." The author invariably fails to mention that XYZ fund has traded at that discount level for a long period, even as he's implying that the share price will go up to the NAV, thus eviscerating the discount (and heaping gain into his readers' laps). Such advice is unhelpful at best and a money-losing proposition at worst. If you find a suitable CEF trading at a discount, take a look at the one-year z-statistic located on our website (for an example, click here). This metric will tell you where the discount currently is compared to where it has been in the past year, taking into account volatility. If the z-statistic is negative, it is lower than its volatility-adjusted average, and vice versa. We consider any z-statistic below negative 2 to signify that a CEF is truly cheap.

Second, avoid CEFs trading at high premiums. If you are screening for suitable funds and find a CEF trading at a 10% or higher premium, delete the CEF from your screen without a second thought. In fact, when you are starting off, you may want to avoid all premium-priced CEFs. Nobody likes paying too much, but I personally don't mind paying slightly more for a long-term investment that is well managed and has a good long-term track record.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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