Closed-end funds

CLOSED-END FUNDS

Click here to see a partial list of closed-end funds.

Closed-end funds are a special type of mutual fund.

Conventional mutual funds that are familiar to most investors are “open-end” funds.

When you buy an open-end fund, you purchase shares from the fund itself, even if you buy through a broker. The price you pay, the net asset value (NAV), is the value of the fund’s holdings (assets), expressed on a per-share basis. The open-end fund’s share price depends solely on its NAV, not on how many investors want to buy or sell its shares.

The downside of an open-end fund is that its manager must find places to invest new money coming from newly created shares when more investors are buying than selling. Conversely, when sellers outnumber buyers, the manager must sell shares he or she might not want to sell to raise cash to redeem the shares.

Closed-End Funds Have Advantages
A closed-end fund sells a fixed number of shares when it starts business via an initial public offering (IPO). After that, the fund doesn't buy or sell shares. New buyers must purchase from existing shareholders. Conversely, shareholders must find a buyer if they want to sell.

Closed-end fund shares trade on the open market just like stocks. Share prices depend on the forces of supply and demand for the fund’s shares, and rarely trade at the net asset value (NAV). Shares are said to be trading at a premium when changing hands above their NAV, and at a discount when below.

The advantage of the closed-end structure is that fund managers have a fixed amount of capital to invest. They can make long-term investment decisions without worrying about raising cash to redeem shares, or finding places to invest unexpected new cash.

This stability seems to lend itself particularly well to funds that focus on paying high dividends to shareholders, and those are the closed-end funds of interest to us.

Besides for their overall fundamental outlook, there are four important factors to keep in mind when evaluating closed-end funds: discount or premium to NAV, leverage, distribution policy and return of capital.

Discount/Premium to NAV
New closed-end funds typically trade at a premium to NAV when first issued. But after a few months, most trade at a discount. A fund’s current discount or premium reflects its popularity. Funds that are “in-vogue,” typically trade at a premium, often as high as 20%, and sometimes even higher. Funds generally trade within a discount/premium range. You can see a fund’s discount/premium historical range on sites like ETF Connect (www.etfconnect.com).

Assuming a sound long-term fundamental outlook, there is an advantage to focusing on funds trading at an unusually high discount compared to their historical range. Ideally, you’ll enjoy capital appreciation when the fund reverts to its usual discount range. But even if a reversion doesn’t occur, you should benefit from the higher yields resulting from purchasing income producing assets at a discount.

Leverage
Many closed-end funds employ leverage, meaning they borrow funds, to increase returns. The math works like this. Say you can borrow money at a 4% short-term rate and invest it in longer-term assets returning 7%. Using those numbers, you’re making 3% annually on the borrowed funds. Leverage works great as long as the spread (yield curve) between short- and long-term rates doesn’t shrink too much. However, a narrowing spread between short- and long-term rates will sink profit margins. Predicting interest rate spreads is difficult, but, in general, spreads tend to narrow in a rising interest rate environment.

Distribution Policy
Like mutual funds, closed end funds generally do not pay tax at the fund level on amounts distributed to investors. The taxation is said to 'pass through' to the shareholders. Thus, since capital gains vary unpredictably, that practice makes dividend payouts equally unpredictable.

Consequently, some funds have instituted a managed distribution policy to make the distributions more stable. In those cases, the fund distributes a fixed percentage of its net assets regardless of its actual interest income and capital gains.

Return of Capital
In instances where a fund with a managed distribution policy doesn’t earn enough to pay the dividend, it funds the shortfall by dipping into its capital, which reduces its asset value. That portion of the dividend is designated as a tax-free return of capital. All funds with managed distribution policies will have to dip into capital occasionally, but funds that do it consistently are reducing the asset value of the fund, which diminishes share value.

Unfortunately, the only reliable way of finding the amount of return of capital included in a dividend is by checking each fund’s press releases, SEC reports, and information on its website. Return of capital data shown on sites such as ETF Connect is unreliable. However, since using capital to pay dividends reduces the NAV, you can see the results of relying on capital to fund dividends by looking at a long-term NAV chart, which you can see on ETF Connect. Avoid funds with downtrending NAV.

Finding Closed-End Funds
MSN Money’s Deluxe Stock Screener is the only screener that I know of for finding closed-end funds based on dividend yields. Get there from MSN Money’s homepage (money.msn.com) by selecting Investing and then Stock Screener. If you haven’t already done so, you’ll have to download some special software, but the software and use of the screener are both free.

You only need two search parameters. Start by selecting “Closed-End Fund – Equity,” which you can find in the Industry Name section under Financial Services. Then specify a minimum dividend yield. Here’s a link to a screen using a 6% minimum yield.

Abnormally high dividend yields, say 12% or higher, probably signals that something is wrong. It may be that the fund paid a one-time or special dividend that has mistakenly been recorded as a recurring dividend, resulting in a incorrect dividend yield. If that’s not the case, it’s likely that many investors think the fund will have to reduce its future payouts.

ETF Connect (www.etfconnect.com) and Morningstar (www.morningstar.com) both list closed-end fund data, but ETF Connect gives more complete information.

I don’t have room to tell you everything you need to know about closed-end funds here, but Morningstar’s Closed-End Funds discussion board is a surprisingly good learning resource. Unlike many stock market message boards, the discussions are polite and many knowledgeable people willingly share their expertise. Get there from Morningstar’s homepage by selecting Discuss and then Closed-End Funds.

Click here to see our picks (Premium subscription required)