How to Invest in Closed-End Funds (the Ultimate Guide)
Closed-End Funds are one of the best types of investments for building an income portfolio.
The yields are (very) enticing and can be relatively safe and stable. If you know what you’re doing that is.
This Ultimate Guide on How to Invest in Closed-End Funds will show you the unique value of CEF investing and what it can bring to your portfolio.
It will also provide the practical insights you need to be successful in generating more income from your portfolio, in a safe and stable way, all while enhancing your portfolio diversification.
And with that, let’s dive right in!
Closed-End Funds (CEFs), just like Mutual Funds and Exchange Traded Funds (ETFs), are a type of registered investment company that hold a portfolio of assets. CEFs are very diverse and invest in many types of securities:
- Equities – across the different regions, market capitalisations, sectors, etc.
- Bonds – across different regions, government and municipal bonds, corporate bonds, different durations, investment grade, high yield, etc.
- Preferred Stock – across different industries
- Other fixed income investments such as senior loans, mortgages, etc.
- Alternative assets and private equity
- Strategies such as covered-call, long-short, etc.
- And probably others but you get the point
CEFs are actually very close to ETFs (and even stocks) in the sense that they provide instant diversification, trade on a stock exchange and can be bought through a stock broker. Their prices change throughout the day just like regular stocks and ETFs.
The main differences between CEFs versus Mutual Funds and ETFs (and the unique role CEFs can play in your portfolio)
Let’s now dig deeper into what makes CEFs special and how your portfolio could benefit from them.
CEFs have a unique structure
One of the main differentiating features of CEFs is their structure. They typically only raise capital through an Initial Public Offering (IPO), by issuing shares only once.
This means that the number of CEF shares is generally fixed, i.e. they cannot accept new injections of money and that is why the fund considered “closed”.
On the other hand, Mutual Funds and ETFs are open-ended funds and accept new investments on a regular basis by issuing new shares if there is strong demand from investors.
Likewise if supply is strong, they buy back the shares to redeem them.
This is not the case with CEFs.
“That’s great, thanks for the info Here Income, but why is this important?” you might ask.
CEFs trade at a discount or premium to Net Asset Value
Well, this is very important because this characteristic results in the price of CEF shares to reflect supply and demand for the shares from investors at each moment in time. This means that CEF shares can trade at a price (or market value) that significantly deviates from the Net Asset Value (NAV) of the CEF assets.
Net Asset Value is the total market asset value of the holdings of fund minus its total liabilities and the result divided by the total number of shares. In a nutshell, it’s what each share is actually worth.
Contrary to the deviations to NAV characteristic of CEFs, Mutual Funds and ETF prices are always practically identical to their Net Asset Value, reflecting the aggregate of the market price of the underlying securities of the fund.
If supply and demand result in pressures on prices to deviate from NAV, then Mutual Funds and ETFs employ mechanisms to counteract this effect and ensure that the price goes back to trading very close to NAV.
With CEFs no such mechanisms are employed by the provider. If the NAV of the CEFs deviates from the value of the underlying holdings, then so be it.
And this means that CEFs typically trade either at premium or at a discount to NAV.
It is really easy to identify the level of premium or discount to NAV of a particular CEF because the very large majority of CEFs calculate the NAV of their portfolios every business day. And this is public, easily accessible information.
The majority of CEFs trade at a discount to NAV and some high-in-demand CEFs trade at a significant premium to NAV.
All else being equal, discounts to NAV allow you to get a built in capital gain (not dissimilar to buying a property at below market value) and a higher distribution of income from the CEF as a proportion of your purchase costs.
However, sometimes there are very good reasons for why CEFs trade at a discount or at a premium. For example, quality of the management team and sustainability of the income stream, or lack thereof.
CEFs are better suited to holding less liquid assets that could benefit from active management
According to the ICI 2020 Factbook, the Majority of US Mutual Fund and ETF Total Net Assets Were in Equity Funds but in Closed-End Funds, the majority of Closed-End Fund total assets were in bond funds (61% to be exact according to ICI).
“Why this disparity?” you may ask.
Well, I’ve already mentioned the CEF’s unique closed-end structure and the fact that the number of shares is fixed.
This means that there is less buying and selling of the underlying securities (since shares in the fund are being traded directly) saving on the often substantial trading costs associated with less liquid securities such as bonds, preferred stocks, etc.
Additionally, CEFs are relatively small in size (more on that later) and are typically owned by smaller retail investors (large players essentially being kept out due to the size constraint).
Small retail investors like you and me would typically incur the most fees if we were to try to buy illiquid assets directly and CEFs are particularly well suited to addressing this problem.
Another possible reason for why the majority of CEF assets are invested in bonds relates to the fact that CEFs are actively managed.
Now if you are a strong believer in the benefits of passive investing in ETFs, you may be tempted to stop reading here but please bear with me.
Did you know that active investing in fixed income investments such as bonds has historically performed much better relative to benchmarks than active investing in stocks?
There are many different sources that highlight this fact but one which presents it particularly well is this report from Guggenheim Investments. I have also seen quite a few reports regarding active management outperforming passive approaches in the fixed income space.
Now I don’t want over emphasize this point as I am definitely a huge fan of passive index investing and ETFs are the cornerstone of my portfolio.
My main take-away for you here is that if ever there was a case for active management, it would be to invest in fixed income investments through CEFs where the structure seems beneficial to holding less liquid assets and where active management seems more likely to outperform.
Most CEFs use leverage
A majority of CEFs employ some sort of leverage to improve returns and deliver higher income. It does this primarily through structural leverage whereby the Fund will raise additional money through borrowings (and pay interest) or by issuing preferred shares (and pay dividends).
By doing this, the CEF increases the amount of capital at its disposal to acquire assets and if they can invest this additional capital at a return that is higher than the cost of capital (interest rates are low these days after all), then leverage will improve returns of the fund.
Another way CEFs employ leverage is through portfolio leverage, by investing directly in assets such as derivatives, repurchase agreements, etc.
I would recommend avoiding CEFs with a huge allocation to such instruments in their portfolio.
There are limitations to how much structural leverage a CEF can employ and all else being equal, CEFs with less leverage are less risky.
Many of the highest quality CEFs manage leverage quite effectively and keep it at a prudent 30 percent of the portfolio or under.
I am definitely against margin trading and speculating with options. Using CEFs as part of a diversified portfolio could allow you to gain some exposure to leverage in what I consider to be a much more prudent manner.
And prudent is a key word here because leverage works both ways, magnifying the performance both in up markets and down markets. Leverage inevitably increases the volatility.
That is why it is important to choose high quality CEFs, with a track record and that employ a conservative level of leverage.
These will outperform their benchmarks because they are able to successfully capture the benefits of leverage.
On the other hand, the increased risk due to leverage is also one of the main reasons why I recommend CEFs to be a relatively small component of your portfolio allocation.
Finally, from a personal perspective, I have not noticed a huge difference between CEF volatility and that of individual stocks.
Let’s not forget that the volatility of CEFs is dampened somewhat from the fact that they hold a large portfolio of assets. Even more so if you use them to buy less volatile asset classes such as investment grade bonds.
CEF expense ratios can be comparable
Let me start by saying that I absolutely hate investing expenses as they directly eat into your return and their impact over the long term is quite significant.
I diligently analyse the expenses associated with all my investments whether it’s brokerage fees, ETF expense ratios, withholding taxes, etc.
And if you find any ways for me to reduce them further, please don’t hesitate to let me know.
If you’re as touchy as I am when it comes to expenses, then I suggest you take a deep breath and mentally prepare yourself for the next sentence.
CEF investing is expensive! And CEFs typically have huge expense ratios ranging from 1 to 3 percent. Some maybe a bit less and others a bit more.
You may be tempted to discard them entirely at this stage, but please bear with me.
Firstly, CEF total expense ratios include interest expense which reduces comparability with Mutual Funds. CEFs interest expense can be more than 50 percent of the total expense ratio.
As I mentioned in the section on CEF leverage, interest expense could be a source of benefit from the leverage, if it is employed profitably. If we don’t consider them as a pure cost, you will see that Management Fees of CEFs are mostly comparable with those of actively managed Mutual Funds.
“But I don’t invest in Mutual Funds, because they’re expensive, so thanks but no thanks” you might say to yourself.
Indeed, I don’t invest in mutual funds for that very reason and also because I doubt the value of active management to outperform net of fees, when it comes to stocks that is.
As I mentioned previously, CEF investing is beneficial for investing in illiquid assets and in fixed income investments. The fees could be somewhat justified in these cases.
If CEFs play a unique role in your portfolio, in less liquid assets or investment types that you wouldn’t invest in otherwise and that give you some leveraged exposure through a structure with unique characteristics, then it could very well be worth it.
Add in the fact that the high yield of CEFs are reported net of fees, and the fact that you can identify CEFs with a track record of sustainable distributions and of consistently beating their passive benchmarks, then the business case definitely becomes even stronger.
If that’s not enough for you, then how about the fact that you can buy CEFs at easily identifiable discounts and relative discounts to their historical range? 5%, 10%, 15% is not uncommon!
That alone is worth the extra 1% here or there. It’s about seeing the bigger picture.
I’m not trying to minimise the impact of fees, I would definitely not recommend using a CEF that more or less mirrors the S&P 500. Unless I was planning to invest on margin at a cheap interest rate (paid by the CEF) that is, which I never plan to do.
However, even then, sometimes the discounts are too high to pass up and you’ll occasionally see an equity CEF in my portfolio.
I conclude by reiterating that I am very conscious of fees and that CEFs are currently the only investment vehicle where I would consider paying such high fees.
The best fund sponsors definitely deserve it and long may they continue to do so!
CEFs give you more income
CEFs are one of the best investments for income because they are structured with the income investor in mind, and boast above average yields as a result.
While it is possible to find many different types of investments that generate high yields, many of which I discuss at Here Income, CEFs are particular in the sense that they deliver high yields in a different way.
They do so primarily due to the fact that they employ some level of leverage as I presented earlier.
This leverage juices up returns over and above the weighted average yield of the holdings.
The best CEFs use leverage prudently and successfully fulfil their promise of delivering a higher yield in a relatively safe and sustainable manner.
Another main reason CEFs are able to deliver higher yields is that most of them trade at discounts to their Net Asset Value.
This allows investors to purchase that future income stream at a lower price and enables them to obtain a better yield then if they did not benefit from such a discount.
Finally, many CEFs are able to deliver higher yields because they distribute the capital gains from the underlying holdings on a systematic basis.
Many investors, including myself, plan to hold securities for the long term and refrain from selling shares to generate income.
The best CEFs on the other hand attempt to keep their Net Asset Value stable or slowly rising over time.
So if holdings appreciate over time, this increases NAV and the CEF will opt to distribute the excess to investors so as to bring the NAV back down to the target level. Instead of having to sell shares yourself, the CEF does it for you.
Now, I definitely favor CEFs that minimise the distributions of capital gains while still maintaining a high and stable distribution. In fact, most of the best CEFs for fixed income investments very rarely distribute capital gains.
Most equity CEFs on the other hand, realise and distribute capital gains to investors. This is not bad per se, but it’s important for you to understand that it’s part of the uniqueness of CEFs. They are really geared towards income versus portfolio growth.
But this is also one of the reasons why I favor CEFs for fixed income investments over equities. I can scratch my equities itch elsewhere, with ETFs, individual stocks and REITs.
I want to highlight that income investors definitely find value in a reliable and stable distribution so many CEFs apply what is called a “managed distribution policy”.
Essentially this means that the CEF fund manager estimates the income and capital gains for the year and then evenly spreads out the distribution to ensure as stable an income stream as possible.
With this in mind, let us go over the different components of CEF distributions to investors as it is a very important factor to understand in CEF investing. These are:
- Dividends – from equity holdings such as ordinary shares and preferred shares
- Interest – from fixed income holdings such as bonds, loans, etc.
- Realized capital gains – by selling holdings at a profit that is distributed to investors as we mentioned earlier
- Return of Capital – by returning capital to investors
Now this last one can be quite dangerous so it deserves more explanation.
You see, return of capital may occur under different circumstances not all of which are bad. These are:
- Pass-through – when a subset of the underlying holdings have provided a return of capital (this typically occurs with Master Limited Partnerships, which I don’t individually invest in as they are very tax inefficient for EU investors)
- Constructive – when they distribute from their cash balance but in relation to unrealized capital gains. Instead of selling the security, they decide use some of the cash on hand.
- Destructive – literally giving you your money back, net of expenses so charging you for that service. This could happen for example, when the Fund is struggling and does not want to cut the distribution to give the illusion of stability.
While the proportion of a distribution that comes from Return of Capital can be found on certain , Fund reports or even your, you don’t get a direct split across pass-through, constructive or destructive Return of Capital.
Generally it’s best to avoid a CEF with a relatively large Return of Capital component, especially in the fixed income space.
Alternatively, If you identify that a CEF has quite a large Return of Capital component to its distribution, then the easiest way to identify whether its problematic or not, and the way I do it myself, is simply to analyse the long term NAV trend.
Is the long term NAV relatively stable? If so, then the Return of Capital is probably not a huge issue. If it’s down trending, then I recommend avoiding the investment altogether and looking elsewhere.
CEFs are a lot less popular with investors (so it’s easier to compete)
According to the Investment Company Institute (ICI) 2020 factbook, the reference in the US on investment companies and related data, US registered investment companies held around 26 Trillion (with a T) USD total net assets at year-end 2019.
The table below shows the total net assets held and the number of Investment Companies across Mutual Funds, Exchange Traded Funds and Closed-End Funds as documented in the ICI’s 2020 Factbook.
As you can see, the total net assets of CEFs are just a fraction of its Mutual Fund and ETF cousins.
But $278 Billion remains a very investable size and the fact that CEFs are relatively small means that large institutional players are often kept out of the space. A positive for the astute retail investor.
The number of CEFs has been trending down having peaked at 664 funds in 2007 but the Total Assets has remained more or less stable over the last decade. This is one reason why I recommend prioritizing the larger CEFs (by market capitalization).
Practical recommendations on how to invest in CEFs
This is a long post so well done on making it this far and thank you for sticking with me!
I would like to conclude with my practical recommendations on CEF investing. They are based on my investing experience and will put the key take-aways of this post into a practical context. Here we go!
- Use CEF Connect “Fund Screener” to screen for CEFs. It is an amazing tool (I am not affiliated with them in any form, I just simply and wholeheartedly recommend them).
- Prioritise CEFs for fixed income investments and investing in more illiquid assets. They need to plug a specific gap in your portfolio.
- Make sure you understand the characteristics of the underlying holdings.
- Try to identify the best CEFs that trade at a discount to NAV.
- Some of the best quality CEFs trade at premium to NAV, buy these when the premium has narrowed to close to NAV or at NAV, usually during downturns.
- Watch the long term NAV trend, make sure it is relatively stable over time.
- Privilege CEFs with a long history and track record (inception before the Great Financial Crisis ideally).
- Watch the long term distribution level, make sure it is relatively stable over time.
- Analyse the different components of the distribution (dividends/interest, capital gains or return of capital).
- Make sure that you pick the larger CEFs in terms of market capitalization.
- Watch the leverage levels and try to target CEFs with leverage of 30% or under.
- Don’t worry too much about expense ratios, distribution yield is net of this number. Look at the expense ratio excluding interest expenses if you want to compare funds.
- Investigate the Morningstar ratings for CEFs, simply by inputting the CEF ticker.
- For European Investors, make sure that your broker provides access to CEFs. I use Interactive Brokers. Some European brokers provide very limited access so do check first.
Now all that is left is for you to give CEF investing a go! Start small, learn and watch that income roll in!