As investors have sought to diversify their portfolios with alternative assets, some have turned to closed-end funds (CEFs) as a vehicle for these investments. As is true with most investment opportunities, these funds offer some advantages and pose some risks for individual investors.
Closed-end funds generally raise money for investing only at inception, offering a fixed number of shares in an initial public offering (IPO). Unlike mutual funds, they do not continue to take in money to invest after the initial shares are sold, and as a general rule they don’t redeem shares or buy them back from investors.
Shareholders who want to cash in their CEF investments must sell them, and to facilitate this market, most closed-end funds are traded on a securities exchange. The price at which each fund trades is based not only on the net asset value (NAV) of its investments but also on the supply and demand for its shares in the marketplace. As a general rule, closed-end funds sell at a premium (for more than NAV) when first issued to cover expenses of setting up the fund and then at a discount once the initial shares are sold. In contrast, the market prices of other exchange-traded funds (ETFs) – most of which are index funds – generally track their net asset values pretty closely, according to Morningstar.com.
According to the Closed-End Fund Association (www.cefa.com), investors have more than 500 CEFs to choose from. While the majority of these funds invest in tax-exempt bonds, many of the taxable funds focus on specific sectors that are considered alternative investments. A few of today’s funds have been around since the Great Depression, and some investors have held their shares for decades and passed them down through the generations. However, most CEFs now on the market were set up after 1990.
Closed-end funds pay distributions to investors on a regular schedule, and the pay-outs of many funds are closer to those of debt instruments than to equities. Unlike most bonds, however, closed-end funds tend to make distributions more frequently, on a set monthly or quarterly schedule. CEFs’ distribution histories are also factored into their selling prices as investors recognize the benefit of a steady cash-flow from them.
Because CEFs have a set number of shares, managers don’t have to sell assets to meet withdrawal demands or buy assets to meet targets when new deposits come in. However, the fluctuation in NAV poses a risk that investors will lose money if the discount increases after they purchase shares.
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According to Rebecca Schreiber, CFP®, a fee-only financial planner with Solid Ground Financial Planning in Silver Spring, Md., closed-end funds tend to have low expense ratios, and this makes them popular with young investors who are “very interested in growth in their retirement accounts and also sensitive to costs – they want to make sure their investment doesn’t get eaten up by trading fees.”
Doug Ober, chairman and CEO of two closed-end funds – Adams Express (ADX) and Petroleum & Resources (PEO) – explained that CEFs with a long-term investment strategy have lower asset turnover than many mutual funds, and this lowers the funds’ overall costs. However, he said many investment managers charge fees based on a percentage of assets under management, and this is true for managers of mutual funds as well as CEFs. Another possible explanation for their lower expense ratios is the absence of marketing fees (known as 12b-1 fees), which closed-end funds don’t have because they are not continually marketing their shares to the public.
The long-term perspective of most closed-end funds offers a particular advantage for investing in alternative assets, such as real estate and commodities, according to Ober. “There are times when a portfolio manager may want to put more money to work, and other times when he doesn’t want to put money to work because he thinks the market may go down,” he said. “With closed-end funds, they aren’t forced to liquidate large portions of their portfolios to meet redemptions or plow money in to invest right now.” Instead, a portfolio manager can decide to leave more of the fund’s assets in cash investments and wait for a more advantageous time to invest it, he explained.
CEFs also may be a good vehicle for investing in commodities that are in relatively short supply, such as oil and copper, and tend to be more volatile, Ober said. “By investing in a closed-end fund through your retirement account, you don’t have to worry about the day-to-day fluctuations in commodities prices,” he said. Schreiber agreed, noting that investing in commodities can be particularly expensive in terms of trading fees. Investing in closed-end and exchange-traded funds (ETFs) that focus on them can give investors “the flexibility to do this without paying a lot of trading fees,” she said.
Schreiber also sees these funds as a good vehicle for investing in emerging markets. Many of her clients are federal employees, and she noted that the federal Thrift Savings Plan (TSP) does not offer many options for growth investments. Some of her clients also have Roth IRAs, and “they can use them to invest in some of these other areas that aren’t covered by the TSP, such as emerging markets that are pretty solid, like Brazil or China,” she said. “They can purchase low-cost funds in those sectors, and it helps them to diversify outside their federal retirement plans and gives them a different avenue for growth.”
Not all financial and investment professionals favor investing in CEFs. For example, Larry Swedroe, research director of BAM Advisor Services and author of the Wise Investing blog, prefers using index funds and ETFs that track alternative assets. He expressed particular concern about the opportunity for a “mismatch of interest between the owners of the fund and the investors.” If a fund trades at a big discount, fund managers could buy up all the shares at discount and then liquidate the fund, he explained. But they don’t buy back the shares or close the fund because that would cut off their income in management fees the fund pays them, he said. Investors buy the fund at a discount, hoping it will close, but instead, the fund continues to pay high fees to the managers while trading at a discount, Swedroe said.
Swedroe also expressed concern that some CEFs might not be very liquid when investors need to access their money. This might be a problem particularly when there is a large spread between a fund’s bid and offered prices. He recommended that prospective investors research the fund’s recent trading activity as an indicator of how liquid the investment might be.
Ober advised prospective CEF investors to research a fund’s range of discounts, which fluctuate over time, and buy when it is selling at a discount near the high end of this range. When the gap between the market price and NAV narrows, investors have an opportunity to make a profit on the investment, he said. He suggested that investors look at other measures as well, including the fund’s portfolio and philosophy, policy on how much leverage it can use, turnover ratio, expense ratio, management longevity and background, and ratings from investment analysts at Morningstar and Lipper.