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By Mike Taggart, CFA | 02-17-2011 02:26 PM

Debunking Five Closed-End Fund Rules of Thumb

Morningstar's Mike Taggart and RiverNorth's Patrick Galley examine five commonly held misconceptions about investing in closed-end funds.

Mike Taggart: Hi. I am Mike Taggart, closed-end fund strategist with Morningstar. With me today is Patrick Galley. Patrick runs the RiverNorth Core Opportunity Fund. It's a 5-star Morningstar-rated fund, and it invests in closed-end funds and ETFs.

Patrick, thanks for joining me.

Patrick Galley: Thanks, Mike, for having me.

Taggart: Lots of times investors don't have a lot of experience with closed-end funds when they first come to closed-end funds. And so they bring with them the frameworks that they have built up over the years for bonds, for stocks, and for mutual funds, simply because they haven't created a closed-end fund paradigm through which to look at these things.

Because of this, there are all these rules of thumb that keep coming across my desk from people who invest in closed-end funds and from those that don't invest in, or even hate closed-end funds. These makeshift rules cover when to invest in closed-end funds, when not to, and what attributes you should look for.

And I thought that with you here today, we could kind of walk through maybe five of the most common ones that I hear and kind of get your take on them.

Galley: Sounds good.

Taggart: The first one is, never buy closed-end funds because they use leverage.

Galley: Well, lot of closed-end funds, almost all closed-end funds use leverage. Approximately 70% of closed-end funds use leverage in their capital structure. The purpose for using leverage first of all is to enhance the yield. I think leverage is very favorable in an environment like we are in today, with a very steep yield curve, when the funds can borrow on the cheap and invest in higher-yielding assets. That's very attractive and accretive to the fund's yield. So we think leverage is definitely favorable.

It is a double-edged sword though, as probably some of your readers are concerned about, obviously, as leverage increases the volatility of the fund. So I think for investors in closed-end funds especially that are using leverage, they need to look at it at the portfolio level, their portfolio level, and take that into consideration on how that volatility affects their overall portfolio. At RiverNorth we incorporate that leverage, that additional volatility into our portfolio analysis, and determine how much exposure we are really taking to various assets classes.

Taggart: Absolutely, and I think that's a smart way to look at it. So on the one hand you get the benefit of higher distribution rate on the other hand you do have that increased volatility. I'd also like to remind people that the amounts of leverage used within closed-end funds is highly regulated, and the average right now among leveraged funds is about 30% of their net assets. So we are not talking like crazy leverage that some of the investment banks got into, it's nothing on those levels.

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