When I talk to investors, I often find that one of the most misunderstood investments is “Closed-end Funds” (CEFs). While investors basically understand the ins and outs of mutual funds, that’s not true for CEFs. The problem is they can be mistaken for mutual funds or exchange-traded funds (ETFs) because they also hold a portfolio of stocks and bonds. However, their operation and their risks can be quite different.
Let’s understand these differences.
Mutual funds continuously sell and redeem shares at the actual value of the underlying portfolio. CEFs don’t; they sell common stock once and don’t redeem shares. Shares are traded on a stock exchange at whatever price supply and demand set. This price can have little to do with the actual value of the underlying portfolio. Thus, CEFs are like ETFs that also don’t continuously buy and sell shares directly to investors. However, unlike CEFs, ETFs have a complex share redemption/creation feature, which generally ensures the share price stays close to the actual value of the underlying portfolio.
Another key difference: Mutual funds are only priced once a day, at 4 p.m., while CEFs and ETFs are priced continuously. However, ETFs and CEFs also release the actual value of the underlying portfolio daily.
While CEFs sell common stock once, they can sell preferred stock and issue long-term debt. Those that do use these funds to buy more of the underlying assets and thus leverage their portfolio. This increases the risk and possibly the return. Mutual funds and ETFs can’t issue preferred stock. While some ETFs use debt to leverage their portfolios, mutual funds are more constrained. Leverage enters in another way; mutual funds can’t be bought on margin while both CEFs and ETFs can. Additionally, mutual funds can’t be sold short while ETFs and CEFs can. The latter two are also allowed to have listed options while mutual funds can’t.
CEFs have more flexibility than mutual funds and ETFs in holding unlisted or illiquid securities; that is, those that possibly can’t be sold quickly at a price close to what the fund claims they’re worth. This flexibility can be a mixed blessing, as the illiquid security’s actual value could differ significantly from the CEF’s estimate. CEFs’ management fees are higher than ETFs’, and often higher than actively managed mutual funds.
Why might an investor consider CEFs?
Since, CEFs’ prices vary from actual value of the underlying portfolio, it’s not difficult to find a CEF investing in the securities an investor is interested in, selling at a discount to the underlying portfolio’s value. This means that an investor could pay less than a dollar for each dollar of assets.
CEFs are complex investments that can, because of leverage, have hidden risks not obvious to a typical investor. While they can provide the opportunity for higher returns, they require careful analysis and a tolerance for potentially higher volatility. Additionally, investors must carefully analyze these “higher returns,” as sometimes, especially for income-oriented CEFs, these returns may partially be a return of investors’ capital, not actual investment profits.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at firstname.lastname@example.org. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.
This article originally appeared on Sarasota Herald-Tribune: ROBERT STEPLEMAN: ‘Closed-end Funds’ have hidden risks for investors