Closed-end funds, or CEFs, are a lesser-known type of investment fund that may benefit income investors who are looking to build a portfolio that provides both diversification and passive income. Similar to other funds such as index funds, mutual funds and exchange-traded funds (ETFs), CEFs pool together funds to purchase a basket of different types of assets, including stocks, bonds, and more.
By investing in them individuals gain exposure to a variety of investments through a single portfolio asset. Many retirees’ investment strategies include CEFs because of their high yields.
What Makes CEFs Unique?
The main difference between CEFs and other funds is that they are “closed,” meaning that investors can’t buy into them at any time they want. Instead, CEFs hold an initial public offering (IPO), similar to a stock IPO, when investors can buy into them and then close sales once the offering ends.
It’s useful to evaluate CEFs based on their Net Asset Value (NAV), which is the sum of the assets in the fund’s portfolio. Brokerage firms post CEF Net asset values on a daily basis. The NAV differs from the CEF’s market price. CEF shares may sell for a discount to their market value, making it beneficial to buy them through the market rather than in their initial offering.
💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.
CEFs vs ETFs: How They Compare
CEFs and ETFs (which have their own pros and cons) have some obvious similarities, and some key differences that investors should be aware of.
CEF and ETF Similarities
• Trade on exchanges during daily trading hours like stocks
• Fund portfolios can be leveraged
• Can offer capital gains and distributions to investors
• Have fee schedules and expense ratios
• Hold portfolios of investments that have a total value
• Investors can trade shares like stocks using margins, shorting, and limit orders
• Can focus on specific sectors or broad indexes
CEF and ETF Differences
• ETFs usually track the performance of an index, whereas CEFs are actively managed
• Investors are more likely to pay capital gains with CEFs than with ETFs
• ETFs can’t issue debt or preferred shares, while CEFs can use these tools to create leverage
• ETFs have features that ensure their share price doesn’t differ very much from their net asset value. In contrast, it’s common for a CEF’s net asset value and share price to be different.
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CEFs vs Mutual Funds: What’s the Difference?
Like CEFs vs ETFs, CEFs and mutual funds have similarities and differences, too.
CEF and Mutual Fund Similarities
• Can pay out income and capital gains distributions to investors
• Run by professional management teams
• Have fee schedules and expense ratios
• Have a net asset value and contain multiple investments
CEF and Mutual Fund Differences
• Mutual funds issue and redeem shares daily, whereas CEFs trade on exchanges
• CEFs can issue debt and preferred shares in order to leverage their net assets, which can increase the amount of their distributions as well as the fund’s volatility
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Types of CEFs
Like other types of funds, every CEF has a different investment strategy and asset size. Funds may hold millions of dollars in assets or billions. Each has its advantages and downsides.
The main issue with small CEFs is they generally don’t trade at high volumes. That means that if an investor holds a large position they can actually affect the price when they buy or sell.
CEF Distributions
CCEFs pay out distributions on a regular basis. These are similar to dividend payments but have some key differences.
Since CEFs include both stocks and bonds, distributions can include bond interest payments, equity dividends, return of capital, and realized capital gains. The tax on the investment income from those earnings may differ between funds since they each have a different asset makeup.
CEF distributions can change over time, so a fund that has a very high payout may make cuts to it. So while an investor may choose a CEF with a high yield, it’s important to keep in mind that it could change over time.
One way to find a fund with an ideal yield is using the distribution-to-NAV ratio. CEFs are actively managed, and the managers need to earn money in order to pay out distributions. So by looking at the net asset value of the CEF compared to its distributions, investors can see whether a CEF will be able to maintain its current yield rate. If the NAV isn’t high enough to maintain a high distribution, the manager may cut the distributions.
One main benefit of CEFs is since they are actively managed, the managers can redistribute investments to maximize returns. However, like any asset, CEFs don’t always perform well. Some CEFs focus on a particular industry, and if that industry isn’t doing well the CEF may not perform well either. The success of a CEF also depends on the management team.
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How to Buy and Sell CEFs
It’s simple to buy and sell CEFs on major stock exchanges, and both beginning investors and those with more experience can participate in the CEF market. Investors can trade them during regular trading hours just like ETFs and stocks, although there are far fewer CEFs available on the market and they have much smaller trading volumes.
CEF Fees
One major downside of investing in CEFs is the high fees. Annual CEF fees tend to top 2%. However, the fees are taken out of the fund so investors may not notice them immediately. Proponents of CEFs claim that they have high fees because they have high quality managers who help the fund earn more money.
Fees can also include the cost of leverage, which is a tool CEFs use to make the fund more profitable. CEFs have more borrowing ability than individuals, so they can greatly benefit from using leverage, making the high fees worth it for investors. Of course, using leverage for investing also brings on additional risk.
It’s important for investors to consider whether paying high fees is worth it based on the performance of any particular CEF.
💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.
The Takeaway
CEFs are a type of investment fund that typically offers diversification and passive income. CEFs have several similarities to exchange-traded funds and mutual funds, but they are closed investments that typically have higher fees and smaller trading volumes.
CEFs are also unique in that they have IPO-like market debuts. In effect, CEFs are something special on the market, and may be attractive to investors for a number of reasons. However, investors would do well to do their homework before investing – as always.
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