investing

Understand How Closed-End Funds Work Before Investing

FINRA urges investors to brush up on closed-end funds, especially the difference between distribution rates and yields.

In today’s low-interest-rate environment, the high distribution rates offered by closed-end funds have become increasingly appealing to investors who are looking for decent yields. However, the Financial Industry Regulatory Authority, the brokerage industry’s self-regulatory body, is warning investors that they need to understand these funds fully before investing in them.

 

“It’s really a 411 rather than a 911,” says Gerri Walsh, FINRA’s senior vice-president for investor education, about the recently issued investor alert on closed-end funds. Money invested in these funds has been on the rise, she says, and about two dozen new closed-end funds have been launched so far this year. With the growth in popularity of these funds, FINRA has received questions and complaints about them. So the timing seemed right to issue an alert to help explain closed-end funds to investors, Walsh says.

In particular, FINRA is alerting investors that they need to understand that a closed-end fund’s distribution rate is not the same as a yield. Like mutual funds, closed-end funds manage a portfolio of stocks, bonds or other securities. A mutual fund’s yield reflects its interest and dividend income. However, distributions from a closed-end fund can also include a return of capital, which means the money comes from the fund’s actual assets rather than income generated by those assets.

For example, say you invest in a closed-end fund with a 5% rate of distribution that’s primarily a return of capital. In effect, you’re getting some of your principal back, says Walsh, which is very different from making a 5% return on interest and dividend income alone. Plus, closed-end funds that return capital can carry a higher level of risk because the asset base needed to generate income to pay future distributions is being eroded, according to the FINRA investor alert.

Keep in mind, too, that closed-end funds’ share prices can vary from the per-share value of their underlying holdings because these funds initially offer a fixed number of shares that trade on an exchange. (Closed-end funds can issue more shares later through rights offerings.) As such, market demand dictates share-price fluctuations. Closed-end funds tend to trade at a discount to the value of their underlying shares, but some trade at a premium. In contrast, the price of a traditional mutual fund is always determined by the value of its underlying assets. FINRA cautions investors to find out from a closed-end fund's Web site (or the exchange where it is listed) how its price compares to its inherent value. Morningstar.com provides information on funds’ historical trading patterns.

In addition, check to see whether a closed-end fund relies on leverage -- making investments with borrowed money, essentially -- to enhance returns. Many closed-end funds do. The risky strategy can pay off when bets go the fund’s way, but losses are magnified when investments go south. Some traditional mutual funds also use leverage. A closed-end fund’s prospectus or annual report will outline if and how leverage will be used to meet the fund’s investment objectives.

None of this means closed-ends funds can’t be good investments. Kiplinger’s Retirement Report recently recommended a few closed-end funds (see Snag Good Bargains in Closed-End Funds) that invest in emerging-markets debt and municipal bonds because the funds were trading at attractive discounts. Just be sure you understand what you’re buying before you buy it.

Most Popular

5 Ways to Prepare for a Recession
recession

5 Ways to Prepare for a Recession

The signs seem to be pointing in one direction these days, so if you’re worried about being ready for a recession, consider taking these five measures…
June 28, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
In What Order Should You Tap Your Retirement Funds?
retirement planning

In What Order Should You Tap Your Retirement Funds?

Should you go with your IRA first or your brokerage account? Pulling money haphazardly can have negative implications. Instead follow this road map fo…
June 28, 2022

Recommended

Top Bear Market Tips from 10 Financial Advisers
investing

Top Bear Market Tips from 10 Financial Advisers

When a bull market turns into a bear market, it can be hard to know what to do. Take comfort in the guidance of 10 financial professionals.
June 30, 2022
Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to
investing

Move Over ETFs: Direct Indexing Is an Investment Strategy Worth Paying Attention to

More flexibility, more control, the potential for higher returns and tax-reducing strategies: With pros like that, could direct indexing be right for …
June 25, 2022
Janus Henderson Global Equity Income Fund Hangs Tough
Kip 25

Janus Henderson Global Equity Income Fund Hangs Tough

A focus on dividend payers and defensive stocks has kept the Janus Henderson Global Equity Income Fund afloat in a rough market.
June 23, 2022
Ron Baron: A Fund Legend Shares Stock-Picking Secrets
mutual funds

Ron Baron: A Fund Legend Shares Stock-Picking Secrets

The ability to buy and hold great growth companies for the long term is important to becoming a successful investor.
June 22, 2022