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

Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
11 Best Healthcare Stocks for the Rest of 2021
healthcare stocks

11 Best Healthcare Stocks for the Rest of 2021

The 2020s could be the decade of healthcare stocks. Here are 10 companies and one ETF to watch not just for the remainder of this year, but well beyon…
July 13, 2021
Warning: You May Have to Pay Back Your Monthly Child Tax Credit Payments
Tax Breaks

Warning: You May Have to Pay Back Your Monthly Child Tax Credit Payments

Unlike stimulus checks, you might have to repay your monthly child tax credit payments if you get too much money from the IRS.
July 16, 2021

Recommended

How to Play the High-Yield Rally
Becoming an Investor

How to Play the High-Yield Rally

Junk bonds have been on a tear, so this fund has shifted to defense.
July 29, 2021
How to Profit From ETFs
Becoming an Investor

How to Profit From ETFs

Exchange-traded funds aren't new, but they're still red-hot. Here’s a detailed look at why you should consider these investment vehicles, both for you…
July 29, 2021
The Case for Investing Overseas
Kip 25

The Case for Investing Overseas

Fidelity International Growth fund tends to thrive during stretches of market uncertainty.
July 29, 2021
Bankruptcy Filings Chalked Up to COVID-19
investing

Bankruptcy Filings Chalked Up to COVID-19

Bankruptcy filings triggered by COVID-19 difficulties continue to pile up. Here, we look at 32 big-name companies that sought out bankruptcy protectio…
July 27, 2021