Newbie Thoughts: Closed-end funds are a good playground for amateur investors

If you only look at the mainstream, easily accessible, investment vehicles out there, closed-end funds tend to be one of the most mispriced assets out there. This means two things. If you are a skilled investor, it is an area where there may be great opportunity to earn high returns. Conversely, if you are a newbie, it's probably one area where you can get burned badly.

For those not familiar, a closed-end fund (CEF) is a fund that has a fixed numbers of shares; whereas an open-end fund (such as a mutual fund or an ETF) creates and destroys (redeems) shares over time. CEFs are generally listed on an exchange and traded daily whereas mutual fund shares are not listed on any exchange (but ETF shares are listed.) Shares of open-end funds tend to track the underlying assets closely but CEF shares may not. There is no natural way to arbitrage price discrepancies in CEF shares (other than through influence of fund managers.)

Two Investment Strategies

In my opinion—I'm not an expert and don't blindly follow anything I say—the ideal fund structure is the ETF (exchange-traded fund.) ETFs have an inherent arbitrage mechanism that keeps the share prices close to the underlying asset price, and, from what I understand, ETFs are also more tax-efficient than mutual funds or CEFs (but it depends on some details.) So ETFs are the way to go. Is there a time when CEFs are better? I think there are two scenarios where CEFs are more attractive. Before I say anything, I should note that CEFs tend to have higher MER (management expense ratio), tend to own illiquid assets, may be illiquid, and tend to be more complicated.

One reason you may favour a CEF is because they tend to be actively managed (most ETFs follow some passive index,) are listed on an exchange (mutual funds are not,) and own unusual assets (such as obscure corporate bonds, asset-backed securities, foreign stocks, illiquid preferred shares and so on.) For instance, one of the most popular CEFs is the India Fund (ticker: IFN), which owns a bunch of Indian stocks. India always had capital controls so it used to be difficult for anyone to buy Indian-listed shares but this CEF would give someone access to locally-listed shares. So the first strategy with CEFs is to buy them because they own assets you couldn't find elsewhere.

The other reason for buying CEFs is to take advantage of a mispricing. CEFs often trade way above or below the assets they own. Sticking with the IFN example, the following chart from ETF Connect shows the premium and discount to NAV:

As you can see from the chart above, the premiums and discounts have been very large at times (as a side note, this chart also shows how contrarian the asset was (basically India was totally out of favour in 2000—a good time to buy for contrarians—and on everyone's radar in 2006—probably a good time to avoid.) Buying $1 worth of assets for $0.60 (2000) is always worth considering so this is the other strategy with CEFs. Mutual funds and ETFs will rarely ever trade at such discounts or premiums.

Some Pitfalls

I started writing this post in order to highlight some of Jason Zweig's thoughts in his WSJ column a little over a week ago. Instead, the post ended up being my view of CEFs. Let me go back to the original idea and highlight some items from Jason Zweig.

Zweig's article talks about some dangers with high-yield securities and he zeroes in on CEFs, which often have high yields.

As of last week, 11 of the roughly 650 closed-ends tracked by Lipper Inc. traded for at least 20% more than their portfolios are worth. In many cases, investors are paying those big premiums in pursuit of high yields.

Buy such a fund, and you may double-dose on risk. A yield that looks stable can crumble; then the premium may collapse as panicked investors dump the fund. That leaves you with less income than you expected—and a big market loss to boot.

Look at Dow 30 Enhanced Premium & Income, which paid out 16.7 cents per share monthly in 2009. At year end, the fund dropped its dividend to 8.5 cents, without explanation. The shares collapsed from nearly a 30% premium to a 3% discount. Investors are left with their income halved on a share price cut by one-third.

So the first thing is to avoid is chasing yield. This goes for any instrument—a bond, a stock, preferred share, whatever.

Another thing to watch out for is return of capital:

Many of these funds engage in "return of capital," an odd but legal tactic that pays your own money back to you. There is nothing inherently wrong with return of capital, so long as the fund's investments are rising in value. If not, the capital returned will eat away the fund's asset base.

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Gabelli Utility Trust, recently at a 60% premium, has paid out at least six cents per share every month since late 2001. Back in 2007, two-thirds came from dividends and capital gains on the fund's investments. Over the past year, however, 90% of the yield has been return of capital.

Return of capital is something that newbies generally don't understand. In some cases, the yield you earn is not "real yield" but is simply the fund or company returning your own capital. You are not really earning anything in that case even though it is a yield you receive. This may or may not be good for you, depending on tax implications, whether you bought the shares at a discount, and various other factors (generally, I would say it is not what you want your company (or the companies held by a fund) to be doing.)

I remember a few years ago when many newbie Canadian investors were tripping over themselves to invest in income trusts—in America, the equivalent would be called royaly trust/MEP/etc—paying out yields of 10% to 15%. What many never realized what a sizeable chunk of the dividends they received were return of capital. Instead of the company paying out a true yield of around 12%, it was only paying, say, 8% yield and 4% return of capital.
So, if you are investing in CEFs, don't blindly take the yield at face value. Also avoid buying CEFs at a premium unless you have a good reason for doing it.

How Come I Don't Own Any?

In regards to the first strategy mentioned above, I have actually looked seriously at several closed-end funds in the past. Like I said, they allow you to get exposure to assets that you otherwise would not have. Good thing I never invested in it but long-term readers may recall me looking at several CEFs that owned various distressed assets. The ones I mentioned in a prior post (in late 2007) would have been a terrible investment (100% loss) since they owned CDOs and mortgage bonds, but it sort of gives you an idea of how CEFs can play a role in your investment if you do make the right decisions. For instance, it would be almost impossible for small investors to invest directly in CDOs or mortage bonds but CEFs would have given you exposure to them. Similarly, one of the other CEFs I sort of mentioned (never really looked at it in detail) was the Morgan Stanley Emerging Market Domestic Debt fund (ticker: EDD), which owns EM debt such as those of Brazil, Mexico, Hungary and the like. It would be difficult for small investors to get direct exposure to such bonds (ETFs are catching up so one should check those first.)

I just never pulled the trigger on any CEF (in regards to the first strategy) but I can see myself doing it if the 2nd strategy was also satisfied.

As for the 2nd strategy (of trying to capitalize on perceived mispricing,) I looked at various closed-end funds in the past but have never invested in a closed-end fund. The main reason is due to my lack of confidence that mispricing will resolve itself in a given amount of time. Most of the time the market does fix the mispricing but I have no confidence in the timing of it. However, I have seen other amateur investors successfully profit off CEF mispricing.

To give an example of the latter strategy, go back to the EM domestic debt CEF (EDD) mentioned above. If you look at its details, you'll find that it is trading at around 15% discount to NAV. Even if you found an ETF with similar holdings, you generally won't find them trading at such a discount (do note that ETFs tend to be more tax-efficient and have much lower MER.) The problem, and the reason I haven't invested in them before, is that there is no guarantee that the 15% discount will close any time soon. If the discount does dissapear, you made an additional 15% but if it doesn't, or if the discount widens, the CEF wouldn't have been better.

Final Word

Overall, I think CEFs are quite attractive as long as you like the underlying holdings, and you can buy it at a discount. If you like making macro-oriented bets, they may be a good instrument for you. Many CEFs also appear mispriced on a regular basis so amateur investors may want to scour the CEF land to see if there are any profitable opportunities.