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Fund Watch

Earn Up to 9% With These Closed-End Funds

Closed-end funds are complicated, but their yields make them worth a look.

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When investors talk about owning funds, they usually mean open-end mutual funds, such as the ones you will find in our review of top performers. Less often these days do you hear much about closed-end funds (CEFs), although their roots can be traced back more than a century. About 500 CEFs trade on U.S. exchanges, compared with nearly 8,000 mutual funds and some 1,800 exchange-traded funds. But CEFs can offer investors a basket of investment assets on the cheap. And they provide juicy payouts that average 8%. If that appeals to you, then these sometimes complicated investments might be worth a look.

See Also: 4 Closed-End Funds with Sky-High Yields

Like open-end mutual funds, CEFs sell shares to investors and use the money to assemble and manage a portfolio of securities. Portfolios might hold U.S. or foreign stocks, including those targeting specific sectors, such as energy or finance. But the bulk of CEFs invest in fixed-income securities.

Whereas traditional mutual funds and ETFs can sell an unlimited number of shares to investors, CEFs issue a set number of shares at an initial public offering, after which they cease to accept new investor money. Instead, investors trade CEF shares the same way they trade stocks or ETFs on an exchange, with their share prices rising or falling with investor demand.

Eighty-five cents on the dollar. That trading dynamic gets to the crux of closed-end funds. Given fluctuations in demand, CEF shares nearly always trade at a discount or premium to the fund’s underlying portfolio holdings—or, more exactly, to the fund’s per-share net asset value (NAV), which is the fund’s assets minus its liabilities. Buying at a discount offers an obvious opportunity. “Ideally, you buy into a good, well-managed fund at a 15% discount, and if expenses are reasonable, you just bought a dollar with 85 cents,” says John Cole Scott, chief investment officer at Closed-End Fund Advisors, a CEF-focused investment firm.

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Investors can realize gains by buying a CEF at a discount and selling if the discount narrows or, more rarely, if the fund begins trading at a premium. But there is no guarantee that the CEF you bought at a discount will eventually trade at or above its NAV, even if a fund’s underlying portfolio is doing well.

However, capital appreciation isn’t the primary goal for most CEF investors, says Joe Hussain, assistant vice president of investment research at Wells Fargo Wealth and Investment Management. “In real estate, it’s location, location, location,” he says. “For CEFs, it’s yield, yield, yield.”

CEFs might generate their generous yields (more accurately called distri­bution rates) by investing in higher-yielding corners of the market, such as low-rated “junk” bonds, real estate investment trusts or master limited part­nerships. But many CEF managers seek to bump up distribution rates by investing more than 100% of their portfolio’s capital. To do that, they most often borrow money, or they issue debt or preferred shares. The extent to which a fund’s invested money exceeds its NAV is called leverage. A fund that borrows 30 cents for every dollar of net asset value is 30% leveraged—about the CEF average. Such leverage can magnify returns if the assets in the portfolio appreciate, but it will amplify losses if things go the other way. Leverage above 40% should raise concerns.

Shop smart. It’s important to put a fund’s discount in context. Compare the fund’s current discount to NAV to its historical average and to the averages for other funds in its peer group. CEFs investing in real estate might look inexpensive trading at an 8.1% average discount to NAV, but they’re actually a little pricier than usual, given the sector’s five-year average discount of 10.2%. High-yield taxable bond CEFs, meanwhile, trade at 7.4% below par, on average—a smaller discount than real estate funds but cheaper than the sector’s five-year average discount of 6.6%.

Instead of gravitating toward the funds with the highest yields, keep in mind that a fund can cut its distribution at any time, and consider whether the distribution policy is realistic and sustainable. Funds must indicate how distributions are funded; check how much of the most recent payout came from investment income, capital gains or return of capital. Each type of payout carries a different tax obligation for investors. Distributions funded by bond interest payments and stock dividends are considered more sustainable than those funded by capital gains. A return of capital, however, means that the fund essentially is handing your money back as a distribution, and it’s a red flag if it consistently eats away at a fund’s net asset value.

Keep an eye on expenses. CEFs charge an average of 1.5% of assets under management, compared with 1.2% for the average open-end diversified stock fund. When borrowing costs are included in the expense ratio—something leveraged CEFs must do—expenses measured as a percentage of total invested assets average 2.4%, but they can range from less than 1% to 5% or more, depending on the amount of leverage and the complexity of the fund’s investment strategy.

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CEFs are thinly traded investments, comparable to over-the-counter or micro-capitalization stocks. Thin markets can be volatile, and the prices at which a buyer is willing to buy and a seller is willing to sell don’t always match up. To help mitigate the risk of overpaying for a CEF (or selling too low), consider using limit orders, which allow you to set a price above which you will not buy or below which you will not sell.

We've identified four funds with robust yields and share prices trading at a discount to the value of their investment portfolios. Check them out: 4 Closed-End Funds with Sky-High Yields.