What’s a Closed-End Fund?

Fund investing has come a long way. Buying mutual funds for the security and convenience of having your money invested by a fund manager is still a popular investment practice—in large part thanks to inertia—but it’s no longer the only fund game in town. Exchange-traded funds, or ETFs, have revolutionized the fund market, adding hedging, sector exposure, diversification and more to the list of reasons why people buy funds. But today, we’re going to talk about a third kind of fund: the closed-end fund, or CEF. 

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, 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.”

As Christ pointed out, many CEFs are focused on providing regular income to shareholders. So it’s no surprise that they make regular appearances in the Dividend Digest. Our last few issues have featured numerous CEFs, with yields as high as 7%, including funds focused on MLPs and fixed-income securities and one with a covered call strategy.

Here’s one of the recent recommendations from the Dividend Digest, written by Jack Colombo, editor of Forbes/Lehmann Income Securities Investor:

Gabelli Healthcare & Wellness Rx Trust (GRX) is a non-diversified, closed-end management investment company whose investment objective is long-term growth of capital through investment in equity and debt securities issued by the healthcare and wellness industries. The fund’s current top five holdings are Beckman Coulter, Nestle, Whole Foods Market, CVS Caremark and Mead Johnson Nutrition. It has 26.1% of its portfolio in the food sector, 18.2% in Health Care Equipment & Supplies and 11.9% in Health Care Providers & Services. Note, then, that the definition of healthcare & wellness by this fund includes food. Recently, the Board of Trustees adopted a quarterly distribution policy and declared an initial $0.10 per share cash distribution payable June 22, 2012. This fund offers medium and high-risk investors diversification in sectors frequently overlooked but very stable. Buy at or below $8.75.”

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Investment of the Week


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