Video Reports

Embed this video

Copy Code

Link to this video

Get LinkEmbedLicenseRecommend (-)Print
Bookmark and Share

By Jason Stipp | 10-18-2011 11:22 AM

A Roadmap to Better Closed-End Fund Investing

Morningstar closed-end fund analyst Cara Esser guides investors through the ins and outs of leverage, discounts and premiums, and distribution rates.

Jason Stipp: I'm Jason Stipp for Morningstar.

As part of Morningstar's "5 Days to Better Investing," we are checking in today with closed-end fund analyst Cara Esser to learn a little bit about the less-well-known closed-end fund and the role that it might play in investors' portfolios.

Thanks for joining me, Cara.

Cara Esser: Thanks for having me, Jason.

Stipp: So, the closed-end fund is similar to the mutual fund and the ETF in that it has an underlying portfolio of securities, but that may be close to where the similarities end. What are some of the key differences that investors who are looking at closed-end funds should think about?

Esser: The biggest difference between a closed-end fund, a mutual fund, and an ETF is a fact that it's closed. The closed-end fund has an IPO just like a stock, and if you would like to buy shares, you have to buy them on the secondary market from another investor. So unlike a mutual fund that you can just put money in and pull it out whenever you want from the manager, you can't do that with a closed-end fund. So, because of the secondary market trading, this gives rise to discounts and premiums. So, this means that a fund's share price may or may not equal its net asset value, which typically it does not, actually, equal the net asset value.

The second biggest difference for closed-end funds, again, because they're closed, these funds can use leverage. So, ... the most common types of leverage are debt and preferred shares. So, borrowing money from a bank or issuing preferred shares, and then using the money to invest in even more assets. So, hopefully, if the market's going up, you are generating more income and more capital gains than you would otherwise, but it also works on the other end, and if the market is going down, the closed-end fund that is leveraged will most likely be hurt more than a fund that does not use leverage.

Stipp: So, that can cut both ways.

So, you mentioned a couple of different dynamics that arose out of the fact that the fund is closed. So, given that there is a different structure here and you can see different effects and different ways that the closed-end fund might perform, what sorts of investments would the closed-end fund structure be good for?

Esser: The closed-end fund structure is very good for income-oriented investors. About 70% of all closed-end funds are actually fixed-income oriented strategies. So, the average closed-end fund that invests in a fixed-income strategy has a 7% distribution rate based on its net asset value, which is fairly high. So these funds..

Stipp: ... And is that juiced by the leverage in some cases?

Esser: Yes, so these funds mostly do use leverage, which is obviously helping the distribution rate, but they also are legally bound to distribute most of the income and capital gains that they earn each year. So, as long as they are earning income and capital gains, they have to distribute it, which is really sort of why the closed-end funds get their reputation for being good for income.

Read Full Transcript
{0}-{1} of {2} Comments
{0}-{1} of {2} Comment
  • This post has been reported.
  • Comment removed for violation of Terms of Use ({0})
    Please create a username to comment on this article