Many readers, especially those recipients of my Wealth Tips Newsletter (sign up on right) write in with money questions.
Recently a reader asked, Should I Invest in a Bond Fund Now?
Today, Prasad asks: “What are your thoughts on Closed End Funds and their suitability as income source? I have been reading about them — on the surface they look attractive but trade press does not seem to talk about CEFs at all.”
As many of you know, I’ve been investing for decades and have put my funds in a variety of investment opportunities over the years. That includes closed end funds as well. Truth be told, I have not invested in a closed ended fund in many years as ETFs and Index Funds have filled my portfolio.
WHAT ARE CLOSED END FUNDS (CEF)?
A fun bit of investing history; closed end funds predate open end or mutual funds. So, what exactly are closed end funds? They are similar to mutual funds, but……
The closed end fund invests in any number of different types of securities. For example, the closed end fund might hold all stocks, all stocks of a certain type such as all preferred stocks, or any combination of holdings.
Simply, a company issues a limited number of shares of a fund filled with any variety of financial assets and then the fund trades like a stock on an index. Once the holdings are purchased for the fund, that’s it. The individual holdings within the fund do not trade but are held in the CEF.
The funds actually have two values. The first, is the underlying net asset value (NAV), which is the sum total of the value of the underlying assets on any given day. You can’t buy the fund for the underlying value. The sales price is determined by supply and demand, and is the price the fund trades at in the market. That selling price might be either a premium or discount to the underlying value of the assets.
Closed End Funds, Exchange Traded Funds, and Mutual Funds
Mutual funds issue and redeem shares at the end of the day at the fund’s net asset value.
Closed End Funds do not issue or redeem shares.
The share quantity of CEFs remains constant as does the portfolio of securities and are traded among investors.
ETFs and CEFs both have an underlying portfolio of investments with a NAV and trade on exchanges.
ETFs, and CEFs both trade like stocks on exchanges.
Mutual funds, ETFs, and CEFs have expense ratios, and fee structures. Typically index funds and ETFs have the lowest fee structures.
Mutual funds, ETFs, and CEFs offer distributions of income and capital gains to investors.
According to Morningstar, “ETFs have a redemption/creation feature, which typically ensures the share price doesn’t stray significantly from the net asset value. As a result, an ETF’s capital structure is not closed. CEFs do not have such a feature.”
CEFs can trade at significant premiums or discounts to NAV.
Should I Invest in Closed End Funds as an Income Source?
According to Mike Taggart, CFA at Morningstar, in CEFs are Superior Income Generators, ” While we believe CEFs are, in general, the superior income generators, they are not–as a group–necessarily superior investment vehicles.”
The gist of this article indicates that recently CEFs have beaten their mutual fund counterparts in income generation. But, as I’ve repeatedly stated, you can receive a great income stream, but if the asset value declines, your total return will not reflect out performance. Actually, I discussed just this issue over at Free Money Finance.
My advice to Prasad, in addtion to subscribing to my Wealth Tips Newsletter which includes a free eBook, 20 Minute Guide to Investing is to avoid chasing yield. Today’s interests are at historical lows, and they will rise. The average historical bond yields in aggregate, from Treasuries to Corporates is in the 5-6% range. Invest with an asset allocation that fits your risk tolerance and investment horizon.
Personally, I prefer low cost mutual funds and ETFs. Understand that if you are invested in any type of bond fund right now, when interest rates rise, the value of that bond fund will decline. Interest rates are cyclical and are certain to rise and offer higher yields in the not too distant future.
Keep your investing simple and understand that every investment vehicle has risk and volatility. Look at your portfolio in aggregate and over time. Avoid focusing on the short term ups and downs.
What are you investing in for yield?
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