Reader Question; SHOULD I INVEST IN A CLOSED END FUND?

By in Advanced Investing, Investing, Reader Question | 15 comments

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.

INVEST IN A CLOSED END FUND?

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?

image credit; Buzzbotsuccess

    15 Comments

  1. I prefer individual equities for yield. The fees on some of the CEFs I’ve looked at have been above to what I’m accustomed to.

    101 Centavos

    December 21, 2011

  2. Nice explanation Barb! Like you, I don’t have CEFs in my portfolio. I prefer simple indexing keeping costs low.

    Moneycone

    December 21, 2011

  3. @101 Centavos-Very smart. It’s so important to keep your eye on fees. Fees make a big difference in total return.
    @Moneycone-As you already know, I like index funds and etfs as well. Low cost and easy to manage.

    Barb

    December 21, 2011

  4. I have no closed end funds. My portfolio includes mutual funds and stocks. Since a lot of my retirement will have fixed income (Pension & Social Security), I am invest for growth and income.

    krantcents

    December 21, 2011

  5. I’m wary of the pricing mechanism on CEF’s. Like others above, I prefer individual stocks and plane vanilla index funds.

    Hunter - Financially Consumed

    December 21, 2011

  6. @Krantcents-Anyone with more than 10 years from retirement and an above average risk tolerance should think about equities (stocks) in mutual funds or individually for growth.
    @Hunter-The CEF’s almost always trade at a premium or discount to NAV.

    Barb

    December 21, 2011

  7. Don’t think I’ve looked at CEFs in years. I still like individual stocks but have been warming up to the benefits of ETFs.

    JP @ Novel Investor

    December 21, 2011

  8. Hi JP-For one time investments (as opposed to dollar cost averaging), ETF’s have very low fee structures, but you may have to pay a commission on a buy or sell order. Although certain investment brokers waive the commissions under certain conditions.

    Barb

    December 22, 2011

  9. Why not go with a no-headache dividend paying ETF? I think it would fulfill the income need and provide you with the peace of mind vs tracking dividend paying companies every-time they issue quarterly statements.

    BeatingTheIndex

    December 23, 2011

  10. @Beating the index-You certainly won’t get any disagreement from me with this approach!!

    Barb

    December 23, 2011

  11. I’ve researched CEF’s and I have found them to be too complex and under regulated. Too many hidden items that can cost investors if they are not careful in their research.

    In addition, CEFs usually trade at a discount and rarely at a premium. So if you find a CEFs trading at a premium you can expect the price to fall and if it’s trading at a discount you can expect the price to remain at a discount to NAV.

    Ben

    December 23, 2011

  12. Hi Ben, Thank you so much for sharing your experience. Your comment regarding premiums and discounts is quite interesting and offers some solid information.

    Barb

    December 23, 2011

  13. they are great aka united corp unc tsx been around since 1930s

    norm kinnear

    December 25, 2011

  14. CEFs vary widely it’s hard to make a blanket statement to buy or not to buy. You need to know what’s inside of it. For example, I was looking to buy into a municipal bond fund and found that most of them use 30-40% leverage, borrowing to increase yield. This would necessarily increase interest rate exposure.

    If you are looking for bond like yield without the complexity of funds or high minimums to buy corporate bonds, try preferred stocks. When you buy these, it’s only one bond and its credit details and funding is available in a prospectus. They are easier to understand though they do have the same traits/risks as bonds.

    They also trade just like stocks which makes them convenient. For my own portfolio I’m about 30% invested in preferreds.

    Six Figure Investor

    December 26, 2011

  15. Hi Six Figure,

    Thanks for your viewpoint. Very important to look under the hood of any mutual fund, ETF, or CEF, not to mention individual stock or bond. Valueline and Morningstar have excellent resources to research investment vehicles as do many discount brokers websites.

    Barb

    December 26, 2011

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