If you’re an average investor with a basic diversified portfolio, you’re likely invested in handful of mutual funds and exchange-traded funds (ETFs). But not as many investors are familiar with closed-end funds (CEFs).
However, depending on your investment goals and overall risk tolerance, it may be worth considering adding a CEF to your portfolio.
But first, it’s important to understand what they are and exactly how they operate.
A CEF is an investment vehicle that contains certain features of both open-end mutual funds and ETFs.
Like open-ended funds, CEFs are invested in a pool of various other assets—giving investors immediate diversification for their portfolios.
However, unlike open-ended funds—which can sell an unlimited number of shares, and the prices of which are set at market close—CEFs issue a limited number of shares, trade on a standard exchange, and see price fluctuations like stocks or ETFs.
Because of this, CEFs often trade at a discount to the total value of their holdings—whereas mutual funds are priced based on their net asset value (NAV). This makes CEFs an attractive prospect for many value investors.
But investing in CEFs involves risk, as well. There are hundreds of CEFs for investors to choose from, and each one is unique. It’s important to research any CEF you’re considering before you make an investment.
Here are some questions to consider:
CEFs don’t trade based on their net asset value—their price is set by the market (which considers a variety of factors outside of NAV). Because of this, there are often discrepancies between these two prices—and it swing go either way. If the CEF is trading below its NAV, it’s trading at a discount. If it’s trading above its NAV, it’s trading at a premium—meaning the market has priced it above the combined value of its assets. To invest in a CEF at a premium is essentially to pay more for a basket of assets than you could buy them for individually on the open market.
A CEF trading at a discount may be an appealing investment option—but only if it eventually increases in value. That’s the entire purpose of investing.
CEF investing is based on the assumption that the fund will eventually realize its full value and trade at its NAV. But not all CEFs are equally successful at this. How has the fund performed over the last few years? Has the CEF been closing the gap between its market price and its NAV? Has there been a steady rise in both prices?
In order for a CEF to be a valuable investment, it needs to be increasing its value.
Closed-end funds tend to reward shareholders with higher returns than do open-ended funds, because they’re invested in more income-producing assets. And fixed-income CEFs pay out monthly or quarterly dividends. It’s important to know how those yields are disbursed—particularly if you’re an income investor. (And remember, any yields you hold in a taxable account are subject to income tax.)
CEFs are known for going into debt to increase their assets and boost returns. The reason for this strategy is because it often works. Some of the highest-leveraged CEFs often deliver the strongest results.
But more leverage creates a much riskier investment. It’s important to be cognizant of a fund’s risk profile, as well as your own tolerance for risk, when making a decision about whether to invest.
Like all funds, CEFs come with fees—trading commissions, various expenses, and annual management fees that could be as high as 2% of your overall investment. Not all CEFs boast the same high costs, though. Look for CEFs with lower fees, and make sure you fully understand—and are comfortable with—all expenses involved.
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