How To Invest Using CEFs

CEFs, also called closed-end investment management companies, are different from mutual funds and ETFs because they issue a limited number of shares. That actually makes them more similar to ordinary publicly-listed companies than funds: when a new investor buys into a CEF, they have to buy from someone else who is selling their shares, like with a stock. ETFs and mutual funds, by contrast, regularly issue new shares and buy back old ones (through bank intermediaries).

Being “closed-end” means a few things for CEF investors. Steve Christ, editor of The Wealth Advisory, has explained these consequences well, so I’ll let him take over: 

“The most important difference between CEFs and mutual funds is that the assets in the CEF, and the number of shares outstanding, are fixed. When you buy into a mutual fund or an ETF, the fund gets larger and has to buy more of the assets it’s committed to holding.

“When it comes to mutual funds, size does matter. They can get too big to maintain the performance that attracts investors in the first place. (Warren Buffett has famously said that he could double his money every year if he were running a smaller-sized fund.)

“Peter Lynch, founder of Fidelity and manager of the Fidelity Magellan Fund from 1977 to 1990, averaged a remarkable 29% return every year… Lynch started with $18 million. By 1990, the Magellan Fund had $14 billion in assets. At the start of 1990, the Magellan Fund traded for around $60 a share. Today? It’s around $70 a share.

“And while the Magellan Fund performed well heading into the Internet bubble of 1999- 2000 — hitting a high of $140 — it hasn’t performed well at all in the last 12 years. Much of the reason for that is it’s simply too big to perform well.

“Closed-end funds don’t have that problem. Closed-end fund managers are not forced to buy more assets as the number of investors grows. That means CEFs have a chance to sustain performance.

“Closed-end funds are usually focused on providing dividends, and they employ various strategies to do this. They may own municipal bonds or corporate bonds. They may invest in Real Estate Investment Trusts (REITs) or other classes of dividend stocks. Some will even use leverage to generate consistent cash returns to pay to investors as dividends.

“One particularly attractive aspect of CEFs is that they do not trade based on their Net Asset Value (NAV). A mutual fund is priced according to the value of the assets, divided by the shares outstanding. For this reason, if you sell a mutual fund out of your retirement account, your sale price is determined after the close of the day’s trading. This can lead to less than optimal exit prices.

“The price of a CEF is determined by the market during trading hours. That means you can buy or sell them at any time during the day. It also means it is possible to buy certain closed-end funds at a discount to their assets, or NAV.

“Now, there’s no guarantee that a CEF trading at a discount to NAV will make up the difference. The CEF may be invested in an asset that’s out of favor, or investors may question the manager’s strategy… but a discount to NAV isn’t necessarily a sign of trouble. In fact, we can consider the NAV discount of a well-managed CEF as an insurance policy against a volatile market.”

Comments

You must be logged in to post a comment.