Can they really eliminate the drawbacks of traditional mutual funds?
by Steve SelengutMr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at firstname.lastname@example.org.
January 6, 2017 — A Closed End Fund (CEF) is a publicly traded investment company that invests in a variety of securities such as stocks, bonds, preferred stocks, real estate, mortgages, oil and gas royalties, etc. The variety of sectors, classifications, and geographical representation is every bit as confusing as it is with traditional funds, but the advantages are easy to understand.
Capital is raised by an Investment Company through an initial public offering (IPO) of common stock and the proceeds are invested according to the investment objectives of the fund. Like a traditional (open end) mutual fund, a Closed End Fund has a board of directors, appoints an investment advisor and employs a portfolio manager.
Unlike conventional mutual funds, CEFs do not issue and redeem shares directly with investors at net asset value. CEFs are listed on national securities exchanges, where shares of the Investment Company are purchased and sold in transactions with other investors, just like individual company stocks, and most often not at net asset value.
Most Brokerage Firm Statements will list these securities as Equities or Mutual Funds, not quite in sync with the purpose or nature of the securities contained within. Naturally, your clients should keep this in mind when analyzing the asset allocation of their portfolio… and adjust accordingly.
Although the number of outstanding shares of a CEF remain relatively constant, additional shares can be created through secondary offerings, rights offerings, and/or the issuance of shares for dividend reinvestment.
Existing owners always get the first shot at new shares, in proportion to their holdings, so they can choose to protect themselves from any dilution of interest. Again, vastly different from traditional mutual funds, where dilution is the very nature of the fund.
Many of the advantages of Closed End Funds are discussed below. It should be abundantly clear that this form of investment fund has eliminated nearly all of the drawbacks of conventional mutual funds. The two have very little in common.
Trading Liquidity – Flexibility – Cost
Closed End Fund shares may be bought or sold at any time during the trading day, just like common stocks, and share prices will fluctuate. They are excellent start up investment vehicles for smaller accounts where diversification would otherwise be difficult to achieve. There are no penalties for leaving the CEF when the stock is sold. The only direct cost involved is the commission paid when buying or selling the shares.
Leverage IS an Advantage
Closed End Fund managements borrow money and issue Preferred Stock in an effort to increase the productivity of the investment portfolio.
As long as the short-term interest rates paid to the lenders and the dividends paid to preferred shareholders are lower than the net long-term rates earned by the portfolio, the common shareholders of the fund will earn higher rates than they would without the leverage.
Rising interest rates aren’t nearly as scary as critics would like you to believe. The manager can reduce the leverage, and new investments are made at higher yields. Leverage is not a four letter word. All debt is a from of leverage and, without it, you would probably be peddling to work instead of driving that Mercedes.
Efficient Portfolio Management
Unlike open-end mutual funds, the asset base for CEFs is relatively stable. Without the pressure of constantly investing or redeeming securities based on investor demands, CEF managers are in charge of the fund and use their own experienced judgment to make investment decisions — uninfluenced by the fear and greed of “the mob”.
Due to minimal marketing expenses and typically lower turnover, CEFs have lower operating costs than traditional mutual funds. (Closed End Funds rarely advertise and don’t pay distributors.) They trade like Common Stocks, with the normal variable expenses that trading involves.
CEFs do not impose annual 12b-1 fees, as mutual funds do, BUT they probably do pay the fund manager too much money. Still, if my Closed End Muni Bond fund is generating 6%, in monthly installments, she’s earning it!
Because Closed End Funds trade on secondary markets like other common stocks, there is no minimum purchase or sale requirement. Investors may purchase or sell as little as they like. And don’t expect to receive a prospectus — yet another benefit since such documents are written in unintelligible legalese anyway.
CEFs make distributions according to a prescribed schedule, which allows investors to plan the timing of their cash flow. The actual amount of the distributions may vary with fund performance, interest rates, and general market conditions.
Still, a stable monthly cash flow is easier to create with CEFs than with individual bonds, mortgages, and preferred stocks — and they are significantly less risky. Many funds make their Capital Gains Distributions early in the year following the actual transactions. This may cause some inconvenience for accountants, but think of the potential for income increasing management strategies! [Remember, it’s your accountant’s job to make you happy…not vice versa.]
All true investments involve similar types of risk. Closed End Funds involve the same risks as common stocks: prices do fluctuate; management skills vary from company to company; markets rise and fall; interest rates change. The rules of Investing (Quality, Diversification, and Income) and of Management (Planning, Organizing, Controlling, Decision Making) always apply.
CEFs are not miracle drugs, just another means to the end of creating a more manageable, safer, and more productive portfolio.