The Yin Yang of Closed End Funds

Scott Miller Sr.


Closed end funds (CEFs) are one of the more enigmatic investment vehicles. The CEF universe is a small one when compared to that of open-end funds (mutual funds) and so it is ignored by most investment managers. Accurate, current information about CEFs is less readily available, requiring more research and analysis than open end funds or equities. They involve a lot more work for less pay and are not as profitable for brokerage firms, nor are they particularly attractive to their commission-based salespeople. There are no revenue sharing agreements for the firms or commission trails for the brokers, who earn less money selling CEFs than they do selling the equivalent amount of mutual funds. Because of this, the CEF market is not sufficiently profitable (from a revenue generating perspective) to attract most brokerage firms and too small to attract most money managers. The few financial specialists who can navigate this complex arena are dedicated to providing their clients exposure to lucrative CEF opportunities.

CEFs offer numerous ways to generate capital growth and income through portfolio performance, dividends and distributions, and through trades in the marketplace at beneficial prices. Their shares are listed on securities exchanges and bought and sold in the open market. They typically trade in relation to, but independent of, their underlying net asset value — the value of the fund’s assets minus its liabilities divided by the number of outstanding shares. CEF shares can be bought and sold via daily trading, much the same as shares of other publicly traded securities. When CEF shares trade at a discount — below their underlying net asset value (NAV) — opportunities to enhance investment returns arise.

CEFs are managed according to the fund’s investment objectives and may invest in stocks, bonds, and derivative securities among others. Unlike mutual funds, the market price of a CEF can vary from the value of the underlying NAV. If the market price is below NAV, the fund is said to be trading at a discount. If the market price is above NAV, the fund is trading at a premium. The amount of the discount or premium is measured as a percentage of NAV. For example, a 10% discount means that the market price, the price to purchase or sell a CEF, is 10% below its actual asset value. Conversely, a 10% premium would mean that the market price is 10% above its actual asset value.

CEF/Mutual Fund Comparison

CEFs and mutual funds are similar in that they are both professionally managed portfolios of investments with a net asset value. Each may offer investors income and capital gains distributions. The notion that a CEF is like a mutual fund that’s closed to new investors is a mistaken one, however.

Mutual fund shares are bought and sold directly from the fund at their NAV, which is based on the value of the fund’s underlying securities. Typically calculated at the close of every trading day, a mutual fund’s share price may include adjustments for sales, redemptions or other charges.

CEFs contain a fixed number of shares. Following an initial public offering — the source of the invested capital — the shares are traded on an exchange with a market price based on supply and demand, plus, in some cases, a commission fee (depending on custodian). The invested capital in a CEF is fixed and can change only at the direction of management.

While both have been around for a long time, CEFs are older, having been introduced in the late 19th century. According to Morningstar, there are currently about 7,500 mutual funds with total net assets of $12 trillion. CEFs are a much smaller market with some 570 funds worth roughly $250 billion.

Closed end funds enjoy highly efficient portfolio management compared to mutual funds. While both CEF and mutual fund investors may panic and sell shares when things are bad or rush to buy shares when things are good, neither event affects the manager of a CEF because redemptions don’t affect the NAV. On the other hand, redemptions can make life difficult for a mutual fund manager because forced selling may have an adverse effect on the fund’s NAV.

There is just one way to earn money owning a mutual fund, that is if the fund’s manager does a good job increasing the value of the underlying assets. There are several ways to earn money in closed end funds. You can even make money in CEFs without the underlying assets increasing in value. See the following chart.

Purchasing CEF shares at a discount to NAV increases the yield. Consider the example of a CEF that generates $0.90 income per share annually with a NAV of $10 and a market price of $9 a share. The yield based on NAV is 9% ($0.90 divided by $10). If you bought a mutual fund at NAV, this is the yield you would receive. But in the closed end fund, the yield based on actual dollars invested is 10% ($0.90 divided by $9).

About the time I began my career in 1972, mutual funds were suffering from a negative image among many investors. One reason was the horrendous experience of thousands of small investors who lost virtually everything they had invested in mutual funds sold by Investors Overseas Services (IOS), the brainchild of fund salesman Bernie Cornfeld.

The way IOS sold their funds was to convince small investors to commit to put a little aside each month. The small monthly saving was likely all that most of those people could afford and represented their hopes for a secure financial future. The aggressiveness of the IOS sales force was driven by the fact that the $100 monthly payment — which represented a $10,000 total commitment for investors over the life of the contract — paid the salesperson an up-front commission of $850! Imagine how long it would take for someone contributing $100 monthly just to reach a point where they broke even, let alone made any money. The purchaser was locked into that commitment and could only exit at a substantial cost.

In early 1970, IOS disclosed that it was short of cash and had substantially overestimated its 1969 profits. Under pressure from creditors, Cornfeld lost control of his crippled company to American financier Robert Vesco, who subsequently siphoned more than $220 million from the company and became a fugitive after being accused of securities fraud. Vesco took up residence on a luxury yacht and avoided the United States warrants for his arrest by remaining in international waters, hopping from island to island and only going ashore surreptitiously to get provisions.

While Cornfeld and Vesco continued to enjoy lavish lifestyles, the many investors who trusted IOS with their meager monthly savings ingested a triple dose of bad medicine. They were saddled with an onerous up-front commission, bought into a fund built on a house of cards that was subsequently liquidated, and lost whatever was left of their money when Vesco absconded with the stolen cash. Sadly, those investors did not have some of the protections afforded investors today.

Because of their high costs, tarnished reputation and deceptive practices, I avoided the entire mutual fund industry and refused to recommend their products. Another reason I decided to look for a better alternative was the emergence of no-load, no-commission funds that provided comparable or even better returns. The writing was on the wall for funds paying their salespeople high commissions. Despite this, mutual funds continued to enjoy popularity among investors and became the largest — and most profitable — component of the brokerage business in the ensuing years. Much of this relates back to Mayday and the introduction of B and C share funds by brokerage firms so their salespeople could reassure investors that all of their money would be invested without any upfront commissions being deducted. What they did not mention were the stiff fees for early redemption and trailing commissions.

To this day, many advisors charge their clients 1 or 2% annually for investing their money into a few mutual funds. That’s not a good value for investors.

After much research, I hit upon closed end funds. At the time, there was precious little information published about the underfollowed market. An example of the sector’s inefficiency was that CEF net asset values were published just once a week in the Wall Street Journal. I had discovered an alternative investment that offered better opportunities for my clients, one I knew they could not successfully explore for themselves.

One of my earliest discoveries was a newer product called a dual-purpose fund. These were unique investment vehicles offering investors the choice of two different securities: capital shares and income shares. Capital shares paid shareholders all capital gains from the fund’s portfolio but none of the income. Income shares paid shareholders all of the income but no capital gains.

There were only seven dual purpose funds in existence at the time and they were not widely followed, again because they represented such a small market and information was hard to come by. I took the time to investigate and was engrossed by the possibilities. Most intriguing was Vanguard’s Gemini Fund, which I was able to buy for my clients at a stunning 26% discount to NAV.

That’s how I first became fascinated with and knowledgeable about the esoteric market of CEFs.

Decades of Uncovering Discounts and Value

There are any number of potential advantages to owning CEFs. They offer the opportunity to buy premier money managers at a discount from net asset value, which means more of your funds are working for you. Most CEFs invest in stocks or fixed income securities and have specific investment objectives, such as income or capital appreciation. Investors can choose funds that match their individual needs. Shares can be purchased conveniently and quickly from exchanges and can be held in a variety of accounts including brokerage, retirement and custodial.

The greatest potential benefit of CEFs is the opportunity to buy shares at a discount to NAV, enhancing returns by providing a dollar’s worth of assets for less than a dollar.

Like mutual funds, CEFs have oversight by a Board of Directors who are tasked to ensure the fund manager is adhering to the fund’s objectives and doing the right thing for fund investors. When a CEF is trading at a large discount from NAV, its Board of Directors may take action to reduce that discount, such as buying back shares at a discount to NAV, whereas mutual funds have no way of doing that.
CEFs tend to enjoy more efficient portfolio management than mutual funds. CEF managers oversee a stable pool of capital whereas mutual fund managers must deal with constant inflows and outflows of cash. CEF managers can execute longer term strategies because they don’t have to worry whether their fund will have enough liquidity to pay back investors who suddenly sell shares, particularly in response to a market decline. Regardless of the sectors where their portfolios are invested, or the trading volume or market price fluctuations in those areas, CEF managers are never forced to sell securities in a declining market to meet redemptions. Conversely, in a bull market, CEF managers aren’t inundated with new cash they must invest at rising prices.

CEF shares can be purchased throughout the trading day, and limit prices can be specified. This is not possible in mutual funds because all orders are executed at the close of business, based on the closing NAV — plus any commissions or redemption fees that may apply.

According to the Closed End Fund Association, “CEFs do not incur ongoing costs associated with distributing their shares as do many mutual funds. The expense ratios of CEFs are often lower than those of mutual funds. Over time, a lower expense ratio provides a boost to investment performance.”

Unlike mutual funds, there are no 12b-1 fees associated with CEFs. These are distribution and service fees paid by mutual funds to cover the costs of marketing and selling shares to new investors and passed on to shareholders.

As mentioned previously, new issue CEFs are sold exclusively through brokerage firms. New issues are when most advisors and brokerage salespeople pay attention to CEFs because it’s when they can make a commission. This is NOT the way to purchase CEFs, however, because equivalent CEF issues are typically available on the secondary market and represent a much better investment. I never buy new issue CEFs, because they sell at a premium when new but invariably sell at a discount on the secondary market shortly after their issue. Our firm buys CEFs exclusively on this secondary market when they are available at a relative discount to their NAV which allows us to control the price and the timing of our purchases.

If the futures market indicates a substantial move prior to opening, we can often buy or sell shares at the previous day’s prices. CEF discounts to NAV invariably widen during periods when the market is down and investors are frightened. Conversely, discounts to NAV will tend to narrow when the market is going up.

Secondary market CEF shares can be an inefficient market, another reason why they present opportunities for profit that mutual funds do not. Investors tend to buy equities of companies they recognize or know something about. They buy IBM or Netflix or Apple because they know what those companies do. That presumed knowledge tends to create efficiency in the equities market. While investors buy CEFs the same way they buy stocks — on an exchange — they typically have no idea what a CEF named “General American Investors” means. They probably have never heard of “Royce Value Trust.”

When investment managers or advisors own a stock that is suddenly down 10%, what do they do? How do they react? The answer is, they don’t really know what to do. They certainly have to investigate why the stock is down. Suppose they learn the reason is that the SEC has accused the company of inflating earnings for the last few years. Now our advisors are thinking perhaps the stock might not be such a bargain, even at a 10% discount. On the other hand, suppose the price of a CEF goes down 5% but the market as a whole is not down, and I like the CEF’s overall portfolio. As an advisor, I have a great opportunity to immediately buy that fund before it goes back up again…because it will go back up as soon as others recognize the opportunity. It’s a much easier and more confident decision.

It’s more difficult to take advantage of information about an individual stock than it is about a CEF that I know well. If a stock plunges in price, it may be difficult to know why. There may not be a rational reason for the drop; whereas when a CEF is available at a discount, it’s much easier for me to determine if it represents an opportunity and move quickly to take advantage.

Even when you know why a stock is down, a CEF may represent a better opportunity. Let’s assume the stock of a drug company is down because of a failed clinical trial. What do you do when that occurs? It’s difficult to know what to do. If that same drug stock is part of a diversified CEF portfolio, the impact of that stock’s drop is nowhere near as significant a factor because it represents a small portion of the CEF’s holdings. It makes it easier to take action.

Bear in mind that while I am talking about daily price movements in the market as they relate to investment opportunities, we maintain a long-term investment perspective. Daily movements are monitored in order to take advantage of price inefficiencies, but they are merely part of an overall long-term investment strategy. It’s one way we add value as a long-term investor.

Our firm currently holds a large position in a CEF that’s been around the better part of a century — shares bought on the secondary market, of course. During the course of a single day, the CEF share price began to fall…1%, 1.5%, 2%, then 3%. It just kept falling! I know the fund and the stocks it contains really well and it made no sense to me that it should be dropping that way…but it was. When something is down and there’s no apparent reason, I try to find out what’s happening because there must be a reason somewhere. It turned out the media had released news that a firm with the same symbol as the CEF we owned was merging with another company and, according to reports, was expected to lose 50% of its assets. Of course, that can’t happen with a CEF. The firm the media was talking about was a mutual fund management company in Europe that had no connection with our CEF. Investors selling the CEF shares were doing so based on totally erroneous information. The fund eventually went to a 20% discount to NAV when it normally sold at 15-16%. That presented us with a tremendous opportunity and those kinds of opportunities happen in the secondary market for a variety of reasons, not the least of which are its inefficiencies.

CEF market inefficiencies tend to correct themselves because there are other people who follow this market. The key for me is daily vigilance to be able to spot these short-term bargains as they occur.

Relative Discounts to NAV

The primary benefit of purchasing a CEF at a discount is to enhance return. But just because a CEF is trading at a discount to its NAV doesn’t mean it’s a good value. A CEF on the secondary market trading at 10% discount to its NAV may appear like a good buy, but perhaps not if the recent average discount is 15%.

An important term is relative discount which refers to the comparison of a CEFs current discount to its average historic discount. If a CEFs average historic discount is 25%, buying it when the current discount to NAV is significantly less — say 10 or 15% — makes no sense, even though technically, you would be buying the CEF at a discount. When buying a CEF on the secondary market, it’s vital to compare its market price against its relative discount, not merely its current discount.

Let’s assume a hypothetical fund ranges from a high discount of 20% to a low discount 10% over a calendar year and the average discount is 15%. (It doesn’t work quite that way because of time periods, but let’s use it as an example.) The high is 20%, the low is 10% and the average is 15%. If you buy that fund at a 10% discount, it’s probably not a good value. If the average is 15%, you are likely to do better waiting until it reverts to its average discount. The same CEF investment will return widely different results because of how and when it is purchased.

It’s important to understand CEF market inefficiencies. Our firm attempts to purchase CEF shares only when they’re trading at a relative discount. We don’t hesitate to sell them at the appropriate time, especially if they go to a premium (selling above their NAV). We look for CEFs trading at relative discounts that can be valued on a daily basis. I refer here to CEFs that have their stock holdings listed on the major exchanges. An exception would be CEFs that are business development companies, which certainly can’t revalue their NAV on a daily basis. That doesn’t mean we won’t buy the CEF, but when we do, we will buy it over a longer period of time. We want to be comfortable with the fund manager’s track record as well as the portfolio, in addition to its relative discount.

While relative discount is an important factor in the purchase of a CEF, it’s not the only factor. As an investor, I have to constantly evaluate whether anything has recently changed that affects my assessment and the discount that now makes sense.

Additional Opportunities to Profit

CEFs offer some additional opportunities to make money through Special Situations.

One such opportunity arises through Activism. CEFs are frequently targets for activist investors who can make a profit by forcing the discount to narrow — even without the need for the fund’s underlying investments to increase in value. Activists can change the whole dynamic of a CEF by purchasing large positions, typically at an attractive discount. Of course, as they continue to accrue shares and increase their position, their actions tend to drive down the fund’s discount. Once the activists have purchased a sufficiently large position, they attempt to force the CEF to take action to make the discount narrow. If that happens and the discount narrows — say from 20% to 8% — and we purchased shares earlier at the 20% discount, we’ve earned 12% on our shares without the overall market or the value of the underlying holdings going up.

There are two actions that CEFs can do to narrow their discount: purchase shares of their own fund on the open market or conduct a Tender Offer.

In the first instance, when the CEF buys back its shares on the open market at a discount, this enhances the NAV for all current shareholders. For example, let’s suppose a CEF’s board authorizes the fund to buy back up to 5% of the outstanding shares at a discount of at least 10%. Now the fund can’t simply go buy all those shares in a single day or week. They have to buy the shares when the discount is attractive (at 10% or more in this case) so it may take six months or a year to accumulate the 5% target. The advantage to both the board and the fund is that by buying shares at a substantial discount to NAV, those shares get redeemed at NAV. So, if they buy shares at $8 and redeem them at $10, they essentially have earned 20% on their own shares for the fund’s shareholders. This is obviously good for both the fund’s performance as well as shareholders, although there is no immediate gratification for shareholders as it takes an extended period of time for the fund to purchase a significant number of the outstanding shares. If I were managing a CEF facing activist pressure, this is how I would react.

The fund management’s other option, the Tender Offer, is not so much what management would like to do but rather what the activists are trying to force to happen. Here the offer to buy shares is typically much closer to the NAV, perhaps 95% of NAV. Investors who tender their shares do alright. They get an immediate payoff since they don’t have to wait for the fund to accumulate shares on the open market. If they bought shares at a 15% discount, or 85 cents on the dollar, and can now sell those shares back to the fund at 95 cents on the dollar, they make a nice profit without the underlying stocks in the CEF portfolio having to increase in value.

Investors who, for whatever reason, do not tender their shares suffer, however. That’s because it costs the fund money to conduct a tender offer, which raises expenses. It’s entirely possible it could cost the fund more money than it pays out. One reason investors might fail to tender their shares is if they purchased them from an advisor who neglects to explain the advantages of the tender offer. This may happen because there’s little monetary incentive for advisors to communicate the benefits since there’s no additional commission to be earned for doing so. On the other hand, an advisor dedicated to his or her clients’ best interests will make certain they fully understand how a tender offer works and the value equation associated with tendering shares.

Thus, when management buys back shares over an extended period of time, while the activists may not be happy, management is doing a better job for the benefit of all shareholders. If management feels compelled by activist pressure to issue a tender offer, not all shareholders benefit: those who fail to take advantage get left behind.

Managed Distributions

An investment company must make distributions of ordinary taxable income (dividends and interest received, net of expenses, and net realized short-term capital gains) and net realized long-term capital gains in order to qualify for favorable tax treatment under the Internal Revenue Service Code. To avoid double taxation (both at the fund level and for shareholders), an investment company will generally distribute substantially all of its ordinary taxable income and net realized long-term capital gains each year.

A fund’s distribution rate is not the same thing as its return. CEFs typically pay distributions to investors on a monthly or quarterly basis and may increase or decrease the distribution rate from one distribution period to the next. Depending on a CEF’s underlying holdings, its distributions can include interest income, dividends, capital gains or a combination of these types of payments. In some cases, distributions also include a return of principal. That means the monies used to pay the distribution come from the fund’s assets rather than from any income generated by the investments in the fund’s portfolio.

Closed-end funds that return capital may carry a higher level of risk because the fund is eroding its asset base in order to generate income to pay distributions. Some CEFs set a specific distribution rate to pay regardless of the income generated by the fund.

For example, a CEF may agree to a managed distribution of 10%. The outsized yield will attract new investors to bid the price up, causing the discount to narrow. This can create an opportunity for current shareholders to profit by liquidating shares, but it typically doesn’t happen quickly. Many times afterwards, the discount tends to widen out to pre-managed distribution levels, providing an opportunity to purchase again, but it usually takes some time for this to occur.

I won’t buy a CEF for my clients just because it pays a 10% managed distribution, but I will buy a CEF with a 10% managed distribution, provided I get an acceptable relative discount to NAV.

Rights Offering

When a CEF wants to increase the size of the fund, their only option is to conduct a Rights Offering, which is an offer exclusively to shareholders to buy more shares. Again, there must be an incentive for shareholders. If the fund is already trading at a 15% discount to NAV, the fund isn’t going to raise any money by offering shares at market price, so they offer shares at a further discount below market price. The offer might also include the opportunity for shareholders to buy an additional share for every three shares already owned, and at a discount to the current market price.

Shareholders may also purchase additional shares (oversubscribe) if other shareholders choose not to exercise their rights. Although funds conducting rights offerings will typically decrease in value after the offering period ends, knowledgeable investors can make a profit by oversubscribing and buying the discounted shares below the market value.

As I mentioned, rights offerings hurt existing shareholders who do not participate because the value of their shares is being diluted. I like rights offerings, however, assuming there is an oversubscription, and typically start off by purchasing a small number of shares. The reason for the meager initial purchase is because it’s almost a certainty that these shares will lose money after the ex-rights date because the discount is likely to widen in anticipation of NAV dilution. Once that ex rights day arrives, I receive the rights to buy more shares, but I don’t want to hang onto the shares I already own any longer because of the anticipated dilution of the NAV. I’m willing to absorb the small loss on the sale of these few shares in anticipation of securing the rights to buy more shares at an additional discount to NAV.

Caveat: There are two kinds of rights offerings: transferable and nontransferable. It’s important to understand the difference. We only buy shares if the rights are nontransferable. Transferable rights can be sold to an outside party on an exchange. Typically, the third parties who buy these rights are large investors seeking to become the primary subscription holders. Thus, they are able to buy up 80 or 90% of the primary offer, leaving only a small available oversubscription, and the oversubscription privilege is where the big money is made. This can’t happen if the rights are nontransferable. In fact, the ideal scenario for us occurs when only a small percentage of shareholders participate in a non-transferable rights offering, leaving the majority of the rights — the oversubscription — available for us to purchase as much as we wish or are able.

Investors like us who understand the nuances of CEFs will sell the initial purchase after the ex-rights date, which causes the stock price to fall. It also causes the discount to NAV to widen. It’s not unusual for a CEF selling at a 10% discount to see its discount widen to 15, 18 or even 20% after the ex-rights date. As holders of the Rights, we exercise the basic subscription rights for common shares. We then oversubscribe for a huge percentage above what we originally owned, subject to availability.

One day back in the early 1980’s, my father called me to ask if I knew anything about a particular CEF. I said I did but why was he asking? He said he owned 1,000 shares of the fund and just received something in the mail about a rights offering. He didn’t completely understand the offering. In fact, few investors did understand rights offerings at the time. I told him I knew what he was talking about and asked him to get the shares out of his safety box and send them to me immediately.

His 1,000 shares were worth about $10,000. I exercised the rights offering for him and I also requested a substantial oversubscription because it was being offered at a 10% discount from the selling price. I was shocked to receive every share we asked for because a lot of investors either didn’t understand the rights offering or ignored it, so there was a huge oversubscription available and we got virtually all of it.

I called my dad and told him I had made him a profit of $17,000. But he remained unconvinced. He asked my mother, “How can those shares be worth $27,000 when they were only worth $10,000 just a few days ago?” My mother said, “Well if Scott said so, it must be true.”

The reality was that simply by owning the rights, I was able to make a huge profit for my dad in just a few days. Those opportunities don’t arise as often as they used to but they do still occur if you know what to look for.

Mistakes Purchasing Closed-End Funds

CEFs can be both attractive and disastrous investments, depending on how and when they are purchased. Understanding and achieving success investing in CEFs requires more time and research than selecting mutual funds, but that’s offset by the potential added advantages. Unfortunately, many investors lacking a comprehensive understanding of CEFs make some horrendous errors and consequently pay a commensurate price for their naivety. Here are some of the more common errors I see people make when purchasing CEFs.

The biggest mistake by far is buying CEFs during an Initial Public Offering (IPO). CEFs have initial public offerings similar to other stocks on listed exchanges. At their IPO, closed end funds trade at a premium to what the underlying securities in the fund are worth, the NAV. Fees and expenses related to the IPO are charged against the capital raised in the IPO. For example, an initial offering price of $25 a share might typically only provide the fund manager with $23.86 cents per share to invest. The fund manager might do a competent job in the first year but look bad because of the discrepancy between the IPO selling price and what the manager gets to invest because of IPO fees and expenses.

On average, this premium is around 5%. This means that when an investor purchases shares of the fund, they are paying 5% above NAV — a blunder. Historically, the premium on the CEF will decrease after the initial offering, providing patient investors the opportunity to purchase the fund at a discount to NAV.

How would you feel as an investor if you purchased a CEF as an IPO with a 5% premium and then saw that CEF quickly plunge to a 10% discount? You would have performed 15% worse than the net asset (NAV) as the CEF went from a premium to a discount. In other words, you essentially increased risk while decreasing return, the opposite of what you should be trying to accomplish.

Never purchase a new issue CEF because the initial premium it trades at will almost certainly go to a discount. Underwriters for these funds may artificially support the market price at the IPO for a short time but it won’t take long for the initial premium to go to discount and opportunities to purchase advantageously will present themselves.

As previously mentioned, one of the big rewards of investing in CEFs is the ability to purchase them at a discount, which means you have more money working for you. The discount is what creates the yield advantage. It’s important to be aware of both the current and the historic discount. 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 relative discount can be advantageous, the exact opposite is true when CEFs are purchased at a premium.

One rationale brokers use to promote CEFs is the high yields these funds pay. This can be a particularly persuasive recommendation in a low interest rate environment. When trading at a discount to NAV, CEFs can afford to pay higher yields than equivalent mutual funds because of the yield advantage. CEF managers also understand that high yields are attractive and some seek to boost their yields to lure more investors. This is when a CEF may decide to increase dividends by paying out not only what the fund earns but also by paying out principal. Purchasing CEFs that are paying out capital is not necessarily a mistake; the mistake is overpaying for CEFs because of a large yield. That’s why it’s critical to evaluate not just the yield, but the relative discount to NAV.

Too many investors overpay for CEFs because of a fat yield. That said, it’s not necessary to avoid CEFs that pay out capital, provided they can be purchased at a proper relative discount. Bear in mind, however, that the principal paid back to you is principal which was purchased at a discount.

“CEFs can indeed be sweet deals for investors when done right. On the other hand, there are dividend traps out there – funds that pay fat yields today, but “eat their own institution” in order to pay their distributions. Long term, they are losers.”

Remember, never buy a CEF at a premium in order to secure a high dividend yield because it’s not a yield; it’s a payment. I’ve recently noticed some unknowledgeable financial people writing about how “such and such fund is a great value because of the high dividend.”

To me, that means nothing.

The reason it means nothing is because a CEF’s dividend isn’t a strength or weakness, since it can be comprised of earnings or merely a return of principle. If you have a high yield, just because you’re getting paid your own money back, that yield is not a show of strength like it may be with an individual company. You can’t look at dividends from a closed end fund as a strength or weakness, much like you would an individual stock.

Another mistake investors make is holding CEFs at a premium. Never be afraid to sell when a fund approaches or surpasses its NAV; you can always buy another one at discount.

I can tell you the exact day a CEF is going to collapse in price: it’s the day the fund cuts its dividend. That’s why I love dividend cuts. If I know the fund and the fund manager, and it’s been trading at a 14% discount from NAV, and the discount widens to 18% due to the dividend cut, I’ll most likely be an avid buyer.

A potential advantage (or disadvantage) is that closed end funds may use leverage. A CEF that does covered-call writing, for example, could be significantly leveraged, which can be an advantage or a disadvantage. The mistake for investors is not whether or not a fund uses leverage, but rather not knowing that it does so.

CEF’s are not an investment arena for dilettantes or dabblers. It’s an onion with many layers and even within the financial community, there are few who know how to peel back the layers skillfully. The complexity of this sector is just one reason why so many investors go astray, and why, after decades of analyzing CEFs on the secondary market, I recommend you find an experience professional to guide you past the hazards.

A few years ago, I was invited to make a presentation to a potential client by his CPA. I choose a fund I wanted to highlight — the NFJ Dividend and Income Fund — as an example of how to buy closed end funds. The reason I chose that fund was to demonstrate why not to invest in an IPO of a CEF and how much a fund can fall from its new issue price. I also chose it because it had cut its dividend, causing its price to fall even further.

The fund was issued in 2005 at 25 dollars a share. I followed the fund closely after it was issued. In 2008, as the market was beginning its downward spiral, the fund’s discount to NAV began a correspondingly precipitous slide. On March 13 of 2009, the fund slashed its dividend. Over a 24-hour period, the discount plunged from 15.38% discount to over a 24% discount. The fund had a redeeming quality: it had a Beta of .92 and was not leveraged, which meant it was less risky than the overall market.

I wanted to show the prospect how I could buy shares of this CEF at a 24% discount from NAV. In addition, the securities in the fund’s portfolio were solid companies and offered excellent diversification. Investors were selling the fund for the wrong reason. It was a wonderful opportunity.

This story has a twist, however. A few minutes before the prospect arrived, his CPA handed me a sheet listing his holdings so I could review them. Low and behold, he owned the very same fund and sure enough, he bought it from his broker at its initial offering of $25 a share. And here I was, about to explain why he should be buying the fund now, at a steep discount to NAV, and not as a new issue. When he sat down, the first thing I did was to have his CPA assure him I had not seen his financial statement until just a few minutes before. I then showed them the example I had in the presentation. I told him, “You bought this at new issue and paid $25 a share for it. Today, it’s selling for $9 a share and I can buy it at a 24% discount to NAV. Whether you decide to do business with me or not, I know one thing: You’re going to fire the broker who made a fat commission selling you that fund at its IPO. The guy responded with an incredulous look but later became a client. By the way, I bought that fund at 24% discount and it turned out to be a tremendous purchase.

Most people who buy CEFs at their initial public offering do so because a broker convinced them it was a smart purchase. It might be a good deal for the broker as a salesperson, but not for the buyer. Investors rarely have enough information to make a sound decision because even the brokers selling CEFs don’t have enough information, other than its an investment they can sell and earn a commission. There’s no way uninformed investors can make a logical decision whether the purchase represents a good value. On the other hand, I can make an informed decision because I know the manager and the portfolio, and I understand the relative discounts available on the secondary market.

Investors should protect themselves by making sure that they have an experienced advisor who understands the complex dynamic of CEFs in order to maximize total returns.




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