Money Matters: The benefits and risks of closed-end funds

By Bozena Pomponio The Daily Record Newswire Closed-end funds (CEFs) are a great way for investors to gain broad exposure to the equity and fixed-income markets. However, these funds are not as well known or as popular as their open-end mutual fund cousins. Let's take a brief look at how this investment vehicle may prove to be a significant positive addition to your portfolio. In a nutshell, closed-end funds issue a fixed number of shares that are traded in the open market at a price that the market places on them, generally at a premium or discount to net asset value (NAV). The shares issued by CEFs do not have redemption value and instead represent partial ownership of the fund. Overall, as of March, there were 628 closed-end funds in existence with over $242 billion in assets. Of the 628 funds, there were 422 bond funds and 206 equity funds. A closed-end fund is a unique investment vehicle that allows an investor to generate capital growth and income through dividends, distributions, portfolio performance and beneficial market prices. Essentially, closed-end funds are a mix between exchange-traded funds (ETFs) and traditional open-end funds. When closed-end funds trade at a substantial discount to NAV, they have the potential to outperform open-end funds when a CEF's discount narrows. Because of this fact, investors who buy shares at a discount are provided a cushion on the downside, while still retaining the upside benefits. Closed-end funds can therefore add value when the discount narrows. Several approaches can be taken by managers and shareholders to further assist in closing the discount. Because CEF shareholders are the owners of the fund, if they believe a fund is being mismanaged, they can utilize their voice as shareholders and vote and/or participate in shareholder activism. This type of activism can result in actions such as tender offers, open-ending, repurchase agreements, or liquidation of the outstanding shares by a fund's management. Ultimately, this activity leads to a narrowing the discount and added value for the shareholders. Another advantage to closed-end funds is their intra-day liquidity. Similar to ETFs, a CEF investor does not have to wait to the end of the day to place a trade. The shares can be bought and sold at any point during the trading day, unlike a mutual fund transaction where all orders are placed at the close of business and the price is based on the closing NAV. Further, many closed-end funds employ leverage to potentially enhance yields and boost returns to investors, particularly with taxable fixed income and municipal closed-end funds. Leverage may be a positive contributor to performance if the rate earned on the investment strategy is higher than the cost of borrowing or issuing preferred shares. Even with all the benefits of investing in closed-end funds at a discount, there are some risks associated with this style of investing. One such risk is the possibility of the discount widening even further than the discount at which it was purchased. For example, if a security purchased at a 15 percent discount widened to a 20 percent discount and the investor decided to sell their shares, this would obviously create a loss. Furthermore, closed-end funds are subject to market risk. Markets rise and fall based on the prices of individual securities and are impacted by economic conditions, investor sentiment and global events. These factors can contribute to daily fluctuations and the overall trend of the markets. The chance of a market decline with the related impact on prices of individual securities and fund shares always represents a general market risk. Although the average investor associates more with open-end mutual funds as a conservative way to invest money, closed-end funds are an option that should be considered. In many cases, an investor could be better served with a closed-end fund vehicle. While open-end mutual funds are played up in the media, it may be time for long-term investors to give closed-end funds a closer look. ---------- Bozena Pomponio is an analyst/portfolio manager for Karpus Investment Management. He can be reached at (585) 586-4680. Published: Thu, Aug 18, 2011