April 12, 2017 | by James Behr Jr & Christopher Paleologus
Closed-end funds (CEFs) are one of the core investments utilized at Blue Bell Private Wealth Management and we think it is necessary to educate people about the mistakes that are often made when purchasing closed-end funds. Below are the five most common mistakes that we believe occur with investors who purchase CEFs.
1. Buying Closed-End Funds During Initial Public Offering (IPO)
Closed-end funds have initial public offerings similar to most other stocks on listed exchanges. At their IPO closed-end funds typically trade at a premium to what the underlying securities in the fund are worth, known as net-asset value (NAV). On average this premium is around 5%. This means that when an investor purchases shares of the fund they are paying 5% above NAV. We view this as a massive mistake. Historically, the premium on the CEF will usually decrease leaving the investor the ability to purchase the fund at NAV or usually at a discount to the NAV. This now allows them to buy the same fund for less than what that actual basket of goods is worth. We believe that when CEFs are trading at discounts, and more importantly good relative discounts, they become attractive investments due to their value.
Our rule at Blue Bell PWM is that we never purchase a new issue CEF because of the initial premium they trade at. Underwriters for these funds may artificially support the market price at the IPO and it may appear to be a normal trend, yet in a few months the price typically drops and opportunities to purchase at a discount may present themselves.
2. Not Demanding a Discount
The biggest advantage to CEFs is the ability to purchase them at a discount. A CEF purchased at a discount means that an investor has more money working for them. The discount is what creates the yield advantage (please reference the chart below). When purchasing CEFs investors must not only be mindful of the current discount but historic discounts as well. For example, a CEF selling at an 8% discount may not be a sound purchase if the average discount over the previous 52 weeks has been 12%. While CEFs purchased at a proper discount may be advantageous the exact opposite is true when CEFs are purchased at a premium or at a discount that is not large enough.
3. Dividends As Return of Capital
One reason why CEFs are recommended to investors is because of the high yields that most of these funds pay. When trading at a discount to NAV, CEFs can afford to pay higher yields than equivalent mutual funds because of the yield advantage illustrated above. CEF managers understand that high yields are attractive to investors and some seek to boost their yields to lure more investors. Dividends are boosted by paying out not only what the fund earns but in some cases paying out principal. Purchasing CEFs that are paying out capital is not a mistake, however, what is a mistake is overpaying for CEFs because of a large yield. In other words when purchasing CEFs the discount to NAV is what should be evaluated not yield. Too many investors overpay for CEFs because of a fat yield.
HINT: A dividend cut may be a great time to purchase a CEF if the dividend reduction creates a significant increase in the discount.
4. Not Considering the Fund’s Strategy
Investors are encouraged to pay very close attention to the historic track records and consistently converse with their investment manager. A big mistake people make is purchasing a closed-end fund because of respectable historical performance. We always remind clients that past performance is not a predictor of future results and more analysis is required. For example, if someone did not look at the track record of discounts for a fund and they see a 10% discount they may think it is a good buy when in fact that fund typically trades at a 15% discount on average.
5. Being Worried About Management Fees
In order to succeed in buying CEFs, you must have a great investment manager that actively monitors your portfolio. Individual investors may be more familiar with other investments such as mutual funds, ETFs and common stocks because their returns can be similar to the returns of the broad market during that time. CEFs are not the same as they offer various ways to make money when the market is down and plenty of ways to lose money when the market is up. It is absolutely essential to find a good manager that has experience with CEFs and understands the ways to maximize returns in the CEF field.
Closed-end funds require substantially more research than purchasing ETFs and mutual funds however it is highly advantageous if CEFs are utilized properly. Further, we believe that investors should make sure that they have a manager that understands the complex dynamic of CEFs in order to maximize the total returns.