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Better than ETFs: How to Pick the Best Closed-End-Funds

10 Best High-Dividend Closed-End Funds

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If you’re like most investors, you probably know little or nothing about closed-end funds. But you should! They offer many advantages over conventional mutual funds as well as exchange-traded-funds (ETFs). Here are the details.

Closed-end funds are similar to conventional managed mutual funds, but with one major difference: rather than selling and redeeming shares as needed, closed-end funds sell a fixed number of shares via an initial public offering (IPO). After that, the fund trades just like a stock. Buyers must purchase from existing shareholders, and shareholders must find a buyer if they want to sell.

Advantages of Closed-End Funds

To appreciate why that’s important, you have to understand a little bit about the psychology of the typical mutual fund investor (present company excepted, of course).

Research shows that most investors pour money into mutual funds long after the market has started to move up. Since mutual fund managers must deploy the new money, they are forced to buy stocks that have already scored big gains.

Conversely, many investors sell their mutual fund holdings after the market has already suffered a big drop. When that happens, fund managers must raise cash to redeem fund shares by selling stocks that are likely trading near their lows. Thus, mutual fund investors force funds to buy high and sell low.

But closed-end fund managers don’t have that problem. Except for portfolio gains and/or losses, they have a fixed amount of money to invest. Consequently, they can make 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 dividend paying investments.

Buy Assets at Discount

Here’s another advantage. A fund’s net asset value (NAV) is the value of its total assets expressed on a per share basis. For instance, if a fund had $5,000 of assets and 100 shares out, its NAV would be $50 per share. Because they create or retire shares as needed, conventional mutual funds always trade at their NAVs.

But that’s not true for closed-end funds. Since share prices reflect the balance of supply and demand, closed-end funds rarely trade at their NAVs. Instead, they trade either above (premium) or below (discount) their NAVs. The good news is that most funds trade at discounts, typically five to 10% below their NAVs. That’s especially important for dividend fund investors because you can get $100 of income producing assets for $90 to $95.

CEF Connect (www.cefconnect.com) is the go-to site for information on closed-end funds.

Here are three more factors to keep in mind: leverage, distribution policy and return of capital.

Closed-End Fund 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 3% short-term rate and invest it in longer-term assets returning 7%. Using those numbers, you’re making 4% annually on the borrowed funds. Leverage is the secret sauce that allows many closed-end funds to pay much higher dividends than similar conventional mutual funds or ETFs. Leverage works great as long as the spread between short- and long-term rates doesn’t shrink too much. A narrowing spread, which could happen in a rising interest rate environment, could pressure profit margins. 

CEF Distribution Policy

Like conventional mutual funds, closed end funds do not pay income taxes on amounts distributed to investors. Instead, the taxes "pass through" to the shareholders. However, since capital gains vary unpredictably, that practice makes dividend payouts equally unpredictable.

Consequently, many 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.

CEF Return of Capital

If 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 "return of capital." If a fund were to do that consistently, its payouts would reduce its net asset value, which, in turn, would reduce its earnings capacity. However, because funds must designate payouts resulting from capital gains as return of capital, you can't assume that payments labeled that way are actually reducing net asset value. You can use CEF Connect to see long-term price charts simultaneously displaying market prices and net asset values. Generally, market prices and net asset values move more or less together. Consistent underperformance of net asset value vs. market price warns that a fund may be selling assets to fund its distributions.

Start Enjoying Closed-End-Fund Advantages Now

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