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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.

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.

Third, be aware that discounts and premiums are really only measures of the relationship between share price and the NAV. Once you purchase a CEF, the only thing you should care about is the subsequent total return. Leaving aside the often high distributions these funds make, if you buy a CEF at $8 per share when it's trading at a 5% discount, you're likely going to be satisfied when the fund is trading at $9 per share even if the discount has widened to 10%. Buy a CEF because it meets your investment objective and is suitable for your portfolio. Treat the discount as potential icing on the cake.

In a recent article, I discussed how CEFs have had higher distribution rates than mutual funds in the same category. It's no stretch to state that many CEFs are created with income-generation in mind. Talking with industry executives, I know this is the case. Just like with mutual funds, CEFs have to distribute most of their net investment income and realized capital gains to investors every year in order to maintain their tax-free status. Many CEFs, being built for income-generation, actually are allowed to distribute both net investment income and capital gains as frequently as every month. But as with discounts, there are a few rules of thumb to adopt, especially on your first venture into CEF investing.

First, regardless of the distribution rate, the only thing to be concerned with is total return. Your net worth won't increase if your total return doesn't increase. Total return is calculated as the change in the share price plus the distribution, all divided by the beginning share price. A few closed-end funds actually return your own capital to you, a practice we call "destructive return of capital," at the expense of the funds' capital, in order to artificially boost their distribution rate. As a result, their total returns are less than the distribution rate. (The NAV goes down because they've mailed off some of their capital.)

Second, if a distribution rate seems too high to be true (an equity fund paying out 15% "dividends"), then it likely isn't true. As mentioned, some funds return capital to investors. You can see whether or not a CEF has a history of doing this on the Quote page on Morningstar.com. At the bottom of the page, we break down every CEF's recent distributions into its component sources. Until you become more familiar with CEFs, you may want to eschew any fund that has a history of consistent return of capital distributions.

Third, try to understand where the distribution is coming from. Unlike mutual funds, CEFs are allowed to issue debt and preferred shares to leverage up their portfolios. The leverage usually allows the CEF to earn and pay out more income than it could have if it were unleveraged. Bear in mind, most corporations use financial leverage, and most have inherent operating leverage to boot. Some investors refuse to consider all CEFs because most CEFs use leverage. This is an ill-thought stance, in my opinion. The average leverage ratio for all leveraged CEFs is only 25%. You can find each CEF's total leverage ratio on the Quote page on Morningstar.com. You can look on the CEF's Ratings & Risk page to see whether or not the fund's total return has exceeded the additional risk (as measured by volatility) induced by the leverage.

Another area where distributions come from is return of capital, as mentioned in the second rule of thumb.

If you follow these six rules of thumb, you will avoid the mistakes that most investors make when making their initial foray into CEFs. Unfortunately, many investors made rookie mistakes during that first foray and have foresworn CEFs altogether. The mistake I hear most often, by the way, is that someone purchased a CEF because of the exceedingly high (and very tempting) distribution rate, and they did so at a high premium. Because the distribution was unsustainable, the CEF cut its distribution and, swiftly, the premium dissipated. Not only do such investors lose out on the distribution, but they incur capital losses as well. If you avoid that mistake, you’ll already be ahead of many investors.

In Germany, I ended up thoroughly enjoying the 15-minute chairlift, with the sun shining on my face and the view unfolding beneath my feet. As I contentedly enjoyed the local ale at the summit’s restaurant while taking in the scenery, I was very delighted that I had stepped out of my comfort zone. The chairlift was, after all, a safe vehicle that allowed me to achieve my objective.

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

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