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6 Things Every Investor Must Know About Closed-End Funds

Point 1: They're not mutual funds.

Mike Taggart, CFA, 10/18/2013

Closed-end funds are complicated investments, at least relative to most exchange-traded funds and especially relative to mutual funds. Investors need to know how to navigate leverage, parse the details of distribution rates, and discern whether a discount represents actual potential value. Have no fear--Morningstar has a collection of educational slides on CEFs here. There are two collections of articles on CEFs and CEF investing here and here.

To make matters even easier, here is a synopsis of six things every potential CEF investor should know.

CEFs Are Not Mutual Funds, Don't Treat Them as Such
Closed-end funds are their own specific investment vehicle. You would not treat your car the same as you would treat your horse, though both are methods of transportation. CEFs should not be treated as mutual funds, or equities, or exchange-traded funds. CEFs do share characteristics with all of these securities (as well as bonds and annuities), but to be a successful CEF investor requires a CEF investment paradigm. Last September, this article kicked off a seven-week series wherein we attempted to help investors understand the nuances and navigate the complexities of CEFs. It's important to understand that within every CEF is an open-end mutual fund. The items built around that mutual fund (leverage, distribution policies, discounts, and so forth) are what make CEFs complex, which makes the market for them inefficient, which in turn makes them great opportunistic investment vehicles.

Leverage Can Be Your Friend
Most CEFs typically leverage their portfolios to produce increased income for distributions to shareholders. Some investors flat out do not like leverage. That's fine. But consider this: If you want to invest in an area of the market, the implication is that you believe that segment is going to perform well; therefore, why wouldn't you want leveraged exposure?

Most investors understand that while leverage can magnify returns (both to the upside and downside), it also increases volatility. So a leveraged fund is likely to be more volatile than a similarly invested unleveraged fund. Two studies spring to my mind on this issue. First, for long-term investors, leverage is typically beneficial--not always, but typically. In 2012, in an article entitled "Changing the CEF Conversation," we included a presentation that showed the effects of leverage over a long time horizon. Slides 9-13 show that leverage, although it magnifies volatility, also amplifies returns. Over long enough time horizons, the outperformance from leverage accumulates, and, typically, not all of that outperformance is given up when the market tanks--even in 2008.

Second, while the leverage increases the volatility of individual CEFs, that volatility can be lessened when viewed in the context of a diversified portfolio. In the examples provided in this article, it was demonstrated that adding more-volatile CEFs to a portfolio of mutual funds would have actually lowered the portfolio's volatility while increasing total returns.

For CEFs, Fees Are Not as Important as Leverage
It is widely known that the best predictor of performance for mutual funds is fees. This is, to a large degree, tautological. The market return would be the gross return for the funds, and, once you subtract the fees, the net return (the reported return) is what you are going to get.

But, again, CEFs are not mutual funds.

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