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CLOSED-END
FUNDS
Click
here to see a partial list of closed-end funds.
Closed-end funds are a special type of mutual fund.
Conventional mutual funds that are familiar to most
investors are “open-end” funds.
When you buy an open-end fund, you purchase shares
from the fund itself, even if you buy through a broker. The price you
pay, the net asset value (NAV), is the value of the fund’s holdings
(assets), expressed on a per-share basis. The open-end fund’s share
price depends solely on its NAV, not on how many investors want to buy
or sell its shares.
The downside of an open-end fund is that its
manager must find places to invest new money coming from newly created
shares when more investors are buying than selling. Conversely, when
sellers outnumber buyers, the manager must sell shares he or she might
not want to sell to raise cash to redeem the shares.
Closed-End Funds Have
Advantages
A closed-end fund sells a fixed number of shares when it starts business
via an initial public offering (IPO). After that, the fund doesn't buy
or sell shares. New buyers must purchase from existing shareholders.
Conversely, shareholders must find a buyer if they want to sell.
Closed-end fund shares
trade on the open market just like stocks. Share prices depend on the
forces of supply and demand for the fund’s shares, and rarely trade at
the net asset value (NAV). Shares are said to be trading at a premium
when changing hands above their NAV, and at a discount when
below.
The advantage of the
closed-end structure is that fund managers have a fixed amount of
capital to invest. They can make long-term investment decisions without
worrying about raising cash to redeem shares, or finding places to
invest unexpected new cash.
This stability seems to lend itself particularly
well to funds that focus on paying high dividends to shareholders, and
those are the closed-end funds of interest to us.
Besides for their overall fundamental outlook,
there are four important factors to keep in mind when evaluating
closed-end funds: discount or premium to NAV, leverage, distribution
policy and return of capital.
Discount/Premium to NAV
New closed-end funds typically trade at a premium to NAV when first
issued. But after a few months, most trade at a discount. A fund’s
current discount or premium reflects its popularity. Funds that are
“in-vogue,” typically trade at a premium, often as high as 20%, and
sometimes even higher. Funds generally trade within a discount/premium
range. You can see a fund’s discount/premium historical range on sites
like ETF Connect (www.etfconnect.com).
Assuming a sound long-term fundamental outlook,
there is an advantage to focusing on funds trading at an unusually high
discount compared to their historical range. Ideally, you’ll enjoy
capital appreciation when the fund reverts to its usual discount range.
But even if a reversion doesn’t occur, you should benefit from the
higher yields resulting from purchasing income producing assets at a
discount.
Leverage
Many closed-end funds employ leverage, meaning they borrow funds, to
increase returns. The math works like this. Say you can borrow money at
a 4% short-term rate and invest it in longer-term assets returning 7%.
Using those numbers, you’re making 3% annually on the borrowed funds.
Leverage works great as long as the spread (yield curve) between short-
and long-term rates doesn’t shrink too much. However, a narrowing spread
between short- and long-term rates will sink profit margins. Predicting
interest rate spreads is difficult, but, in general, spreads tend to
narrow in a rising interest rate environment.
Distribution Policy
To avoid paying excise taxes, closed-end funds must distribute at
least 98% of earned income and realized capital gains to shareholders in
the form of dividends each year. However, since capital gains vary
unpredictably, that requirement makes dividend payouts equally
unpredictable.
Consequently, some funds have instituted a
managed distribution policy to make the distributions more stable.
In those cases, the fund distributes a fixed percentage of its net
assets regardless of its actual interest income and capital gains.
Return of Capital
In instances where a fund with a managed distribution policy doesn’t
earn enough to pay the dividend, it funds the shortfall by dipping into
its capital, which reduces its asset value. That portion of the dividend
is designated as a tax-free return of capital. All funds with
managed distribution policies will have to dip into capital
occasionally, but funds that do it consistently are reducing the asset
value of the fund, which diminishes share value.
Unfortunately, the only reliable way of finding the
amount of return of capital included in a dividend is by checking each
fund’s press releases, SEC reports, and information on its website.
Return of capital data shown on sites such as ETF Connect is unreliable.
However, since using capital to pay dividends reduces the NAV, you can
see the results of relying on capital to fund dividends by looking at a
long-term NAV chart, which you can see on
ETF Connect. Avoid funds with downtrending NAV.
Finding Closed-End Funds
MSN Money’s Deluxe Stock Screener is the only screener that I know
of for finding closed-end funds based on dividend yields. Get there from
MSN Money’s homepage (money.msn.com)
by selecting
Investing and then
Stock Screener. If you haven’t already done so, you’ll have to
download some special software, but the software and use of the screener
are both free.
You only need two search parameters. Start by
selecting “Closed-End Fund – Equity,” which you can find in the Industry
Name section under Financial Services. Then specify a minimum dividend
yield. Here’s a
link to a screen using a 6% minimum yield.
Abnormally high dividend yields, say 12% or higher,
probably signals that something is wrong. It may be that the fund paid a
one-time or special dividend that has mistakenly been recorded as a
recurring dividend, resulting in a incorrect dividend yield. If that’s
not the case, it’s likely that many investors think the fund will have
to reduce its future payouts.
ETF Connect (www.etfconnect.com)
and Morningstar (www.morningstar.com)
both list closed-end fund data, but ETF Connect gives more complete
information.
I don’t have room to tell you everything you need
to know about closed-end funds here, but Morningstar’s
Closed-End Funds discussion board is a surprisingly good learning
resource. Unlike many stock market message boards, the discussions are
polite and many knowledgeable people willingly share their expertise.
Get there from Morningstar’s homepage by selecting Discuss and then
Closed-End Funds.
Click
here to see our picks (Premium subscription
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