Open Your Mind To Closed-End Funds

How we can develop consistent and predictable income

by John Bartlett

Closed-end funds were introduced in the United States in 1893 but 1a Closed-end funds are investment vehicles that pool money from many different investors for the purpose of investing in stocks, bonds, and other assets. Today, there are approximately 450 closed-end funds trading on U.S. exchanges holding total assets of nearly $300 billion; bonds and common stocks comprise the two most commonly used asset classes.

While closed-end funds have many similar characteristics to traditional open-end mutual funds and exchange traded funds, there are some significant differences.

The first difference helps explain the name of the vehicle: closed-end funds issue a fixed number of shares in an initial public offering (IPO) and the funds raised are used to purchase securities. Once the offering is “closed” and the shares have been sold to investors, the fund trades on a stock exchange throughout the trading day. New shares can be raised after the IPO only through a secondary offering, a rights offering, an at-the-market program, or a dividend reinvestment program. In contrast, shares in open-end mutual funds and ETFs are created and redeemed as needed to meet market demand.

We believe the permanent nature of capital in closed-end funds is an advantage to investors who take a long-term approach to investing. This is especially important during times of market stress when redemption requests increase, sometimes forcing mutual fund and ETF managers to sell securities at depressed prices. In contrast, closed-end fund investors who wish to redeem their shares must sell them to another investor. This allows the fund to maintain positions through a downturn and continue to generate income.

Another unique benefit is the ability for closed-end funds to employ a managed distribution program. This feature is especially attractive to retired persons and others seeking stable, consistent flows of income from their investment portfolio. The laws governing regulated investment companies require funds to distribute nearly all interest and dividend income, together with realized capital gains, each year, but the timing and amount of payments usually varies and is not always predictable. But many closed-end funds have received an exemption that allows them to make regular fixed payments on a monthly or quarterly basis.

These consistent, predictable, managed distributions may be generated from a combination of interest income, dividend income, capital gains, or return of capital. A well-managed closed-end fund strives to select securities which, over time, will both appreciate and produce income at levels to meet the monthly or quarterly distribution payments set by the fund.

Once a fund demonstrates that it has been able to meet its distribution obligations, investors may become more confident about the fund’s yield. For example, a fund that consistently distributes 10 cents per share per month, or $1.20 per year, and trades on the stock exchange at a price of $15.00 per share, would have a distribution rate of 8.0%. Investors can then make comparisons with other income-producing investments and develop an opinion about the sustainability of the distributions and the market value of the fund.

Before putting money into a closed-end fund, it is important for investors to thoroughly research the length of time that distributions have been made, the tax status of past distributions, and the reasons for any past changes in the amount of distributions paid. The higher the indicated distribution rate, or yield of the fund, the more cautious investors should be in determining the mix between “earned income” from interest, dividends, and capital gains versus distributions classified as “return of capital.” Investors should exercise caution if a portion of a fund’s distributions, for more than a short period of time, is coming from return of capital.

Unlike mutual funds and most ETFs, closed-end funds are permitted to use debt, or leverage, in order to enhance the generation of income and, potentially, the underlying net asset value. Since there are a variety of risks associated with the use of borrowed money, investors should assess such things as a fund’s past level of debt relative to its total assets, the cost of the debt, and whether the fund has ever been forced by its lender to sell securities during a market downturn.

To sum up, closed-end funds may be attractive to investors, such as retirees, who prioritize income in their investment portfolio. Closed-end funds have several notable differences from mutual funds and ETFs. The permanent nature of the capital held in these funds allows managers to be patient long-term investors and, for those focused on equities, to reap the benefits from the compound growth of dividends. Some closed-end funds utilize managed distribution policies in order to make regular payments, as often as monthly, allowing shareholders to better anticipate their future levels of income and spending. Leverage, when employed prudently, offers the opportunity for enhancement of income levels and capital appreciation.

Like all investments, there are a variety of risk factors to consider. For taxable accounts, be sure to examine the tax efficiency of historical distributions – look for high percentages of qualified dividend income and long-term capital gains. Finally, check to see how much of the distributions are coming from income earned by the fund’s investments relative to how much is from return of capital.