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Behind Closed Doors

Sanjib Saha  |  December 3, 2020

IF YOU OWN an actively managed mutual fund, you expect the fund’s managers to buy and sell stocks and bonds as they see fit—and yet all that trading isn’t necessarily driven by their investment decisions.

Why not? Imagine the fund has had a few years of underperformance. That might prompt impatient investors to take their money elsewhere. This exodus can create headaches for the shareholders who still have faith in the fund. How so? When shares are redeemed, the fund has to pay departing investors their share of the fund’s assets. The fund would have some money set aside for this purpose. That cash, alas, can drag down a fund’s performance in rising markets.

What if there isn’t enough standby cash to cover large outflows? Unless a fund can transfer assets in-kind to departing shareholders—a rare occurrence—it’s required to sell part of its holdings to raise cash. That’s where the trouble starts.

First, a fund’s own selling can further drive down the price of a stock or bond it’s looking to unload, hurting the fund’s return. This selling also generates trading costs, taking a bite out of the fund’s performance. To make matters worse, selling appreciated assets can cause the fund to realize capital gains, leading to big tax bills. Who foots that tax bill? Not those who jumped ship. Instead, it’s the investors who hung tough.

Sound bad? Given a choice, I wouldn’t want the destiny of my funds to be controlled by the actions of my fellow investors. That’s why I became intrigued by a possible alternative, closed-end funds, or CEFs.

A CEF is an actively managed fund that can be bought and sold in the secondary market, just like the shares of any publicly traded company. At its initial public offering (IPO), a closed-end fund raises money by selling a fixed number of shares. The money raised is then invested—but only after subtracting a steep sales commission that’s paid to the selling brokers. Thanks to that steep commission, you don’t want to buy a CEF at its IPO, because you’re effectively purchasing the fund at a premium to its net asset value (NAV), which is the value of the fund’s assets figured on a per-share basis.

After the IPO, CEF shares are neither continuously created for new investors nor redeemed by the fund company when shareholders sell—a crucial difference from a traditional mutual fund. Instead, arriving and departing investors have to buy and sell the publicly traded shares. Since the fund’s managers don’t have to worry about investors pulling money out of the fund itself, they can manage the fund’s portfolio better and even venture into illiquid investments that reward patience.

CEFs date back to 1893, nearly 30 years before the first U.S. mutual fund was launched. Yet there are only 500 or so of them, managing less than $300 billion in assets, compared to almost 8,000 mutual funds that manage over $20 trillion. Why haven’t CEFs taken off?

For starters, CEFs are rarely bought by institutional investors. They also fly under the radar due to limited research coverage by professional analysts. That means the onus is on individual investors to learn about them. Some people also fear that demand for a fund will dry up in the secondary market, leaving them owning a fund with a depressed share price.

Despite those drawbacks, CEFs may appeal to investors looking for higher yields. While many early CEFs focused on stocks, the funds have now become a favored vehicle for everyday investors seeking more income, in part because of three unique advantages offered by the CEF structure.

First, you may be able to buy a CEF at a discount to its NAV, so you purchase $1 of fund assets for just 90 or 95 cents. Buying at a discount also means your yield will be higher than the fund’s portfolio yield. This past spring, during the coronavirus selloff, I got the chance to buy a real estate CEF at a steep discount. You can screen funds by various criteria here, including whether they trade at a discount and what market segment they focus on.

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Second, the closed nature of these funds allows their managers to choose from a broader set of income-producing assets. Some of these investments may be illiquid but promise more yield.

Third, most CEFs borrow money with an eye to boosting both yield and total return. The hope: The long-term return on the additional investments bought with the borrowed money will be greater than the cost of borrowing. Keep in mind that this leverage magnifies not just gains, but also losses, so the ride for fund shareholders can be a whole lot rougher.

Among CEFs that borrow, average leverage is 33%, meaning funds borrow an additional 33 cents for every $1 they have in net assets. One danger: If the market turns south, a highly leveraged CEF could breach its borrowing limit—and be forced to sell portfolio holdings at rock-bottom prices to pay down leverage.

CEF leverage can take the form of loans or it might come from issuing preferred shares. The leverage makes a fund more expensive, thanks to the interest on the loans or the dividends paid on the preferred shares. Leveraged funds also have more assets to manage, and fund managers charge advisory fees on that larger pool of assets. That means leveraged funds are more lucrative for fund managers—but they may not be more lucrative for investors.

Want to learn more? I occasionally check out this visual depiction of the CEF universe and then explore those market segments that interest me.

A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Neglected ChildFatal Attraction and Identity Crisis. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.

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