Closed-end funds (CEFs) are often unknown and overlooked by individual investors. In reality, CEF stocks deserve a closer look, as they provide attractive high dividend returns and can help you create a comfortable passive income. 

We will explain what CEFs are, their benefits and risks as well as how to invest in them.

What Are CEFs?

CEF stands for closed-end fund. The fund managers actively invest in various stocks, bonds, and alternative assets like commodities or real estate. 

To raise capital, CEFs hold an initial public offering, or an IPO. They issue a limited fixed number of shares to raise money. Portfolio managers use the capital raised by the IPO to buy versatile securities to gain profits. The returns will be paid back to the shareholders in the form of dividends. 

After the IPO, shares will be traded on the secondary market — like the New York Stock Exchange or the Nasdaq stock market — during daily trading hours. CEFs do not buy their shares back and usually do not issue additional shares.

CEFs in the United States are well-regulated. An investment company is required to outline its investment objectives and strategies in its prospectus. In addition, it must also list management and administrative expenses. CEF financial results must be publicly available, which provides greater transparency to its investors. The investment funds usually communicate with their shareholders through press releases. 

Types of CEFs

Fund managers aim to balance out risks with returns and to find a proper mix of investments. They may allocate a certain percentage of the portfolio to individual stocks, mutual funds, bonds, and ETFs. 

These are the main CEF types:

• Equity funds: These CEFs invest primarily in stocks and ETFs.
• Taxable fixed income funds: These CEFs invest in corporate debt securities.
• Tax-exempt municipal bonds: These CEFs invest in debt securities issued by local governments (for example, a state or a city). As you can guess by the name, the municipal bonds’ dividends are exempt from tax, but only at the federal level. The investor will be responsible for the state income tax portion.
• Non-traditional funds: These CEFs invest in alternative assets. Some funds invest in precious metals. For example, Sprott Physical Gold Trust (NYSEARCA:PHYS) holds gold bullion, and Sprott Physical Silver Trust (NYSEARCA:PSLV) invests in silver bullion.

Since fund managers can invest the fund’s money in any security, there is an unlimited combination of CEF types. Additionally, CEFs can be global or country-specific, depending on the locations of the securities. They can also be non-leveraged or over-leveraged, based on the ratio of CEF expenses to its assets.

How CEFs Are Different From ETFs and Mutual Funds

A CEF, as an investment structure, has a few distinct characteristics. Here are the key differences between closed-end funds, exchange-traded funds, and mutual funds:

• No share buybacks: Contrary to a mutual fund, a CEF — like an ETF — is not required to buy back its shares from the shareholders. As a result, it can maintain a steady asset base.
• Fixed number of shares: A CEF issues a fixed number of shares at its inception, whereas mutual funds and ETFs can issue additional shares at any time.
• Active fund management: A CEF’s portfolio is actively managed by fund managers, while ETFs track an underlying index and are passively managed. Mutual funds can be either actively or passively managed.
• Trade above or below their net asset value (NAV): CEFs usually trade higher (at a premium) or lower (at a discount) than their NAV, while ETFs and mutual funds are priced very close to their NAV.
• Trade during market open hours: ETFs and open-end mutual funds can be bought or sold after hours, while CEFs are traded in real-time during market open hours, and their dealing prices are not known in advance.

Ways of Increasing CEF Return

The investment management team actively manages the portfolio to produce a stable income for their shareholders over time. Their goal is to achieve a high dividend yield with relatively low risk.

Leverage is an investment strategy used by management teams to reinvest borrowed capital in order to achieve higher returns. It multiplies gains and magnifies volatility, but historically the advantages outweigh the drawbacks.

Note that the Investment Company Act of 1940 heavily regulates CEFs. A closed-end fund must keep its debt ratio under 50% of the fund’s net assets and preferred shares in an amount up to 100% of its net assets.

Fund managers can add leverage to increase a CEF return in a few ways:

• Leverage debt to multiply gains: Fund managers can borrow money in the short-term from a broker (often at lower interest rates) or a bank and invest them to gain an additional return. The return should cover the borrowing cost and bring extra profit to the CEF investors.
• Issue preferred shares: This is another form of leveraging. The CEF can issue preferred shares to raise capital. Preferred shareholders have a priority to claim dividends and company assets but cannot vote.
• Leverage portfolio: By buying, holding, and selling certain derivative investments, the fund managers can leverage the investment portfolio.

Benefits of Investing in CEFs

Often unknown or overseen by individual investors, CEFs deserve a closer look. Let’s review the main benefits of investing in closed-end funds.

High Rate of Return

CEFs typically offer a higher return than the open-end funds. If you are willing to take some risk and invest in more leveraged CEFs, you should expect to get a higher return. But even unleveraged funds can provide a great return by utilizing an option writing (selling) strategy to seek total return performance and enhance distributions. A good example is BlackRock Enhanced Equity Dividend Fund (NYSE:BDJ), whose annual yield as of February 2021 was 6.73%.

Active Portfolio Management

Managed by the best money managers, CEFs could provide you with a large income source you can rely on for years. The fund managers monitor the market for the best additions to the portfolio and focus on long-term growth instead of more aggressive speculation. Keep in mind, you will pay a higher management fee, but it may be worth it for the return on your investment. 

Let’s review Gabelli Dividend & Income Trust (NYSE:GDV) as an example. As of February 2021, the CEF had an expense ratio of 1.2%, a price of $22.84 per share, and an annual dividend of $1.32 (5.82%). As an individual investor, that means that you would receive $1.32 per share yearly, and you do not need to pay an additional fee, as the expense is already embedded in the dividend.

Portfolio Diversification

CEFs are investing in a wide variety of asset classes and investment strategies. Fund managers can create a well-rounded portfolio that produces a high return and is value-driven. Some CEFs hold contrarian holdings to diversify across different economic sectors, while some diversify within the sector. For example, the Virtus AllianzGI Artificial Intelligence & Technology Opportunities Fund (NYSE:AIO) mixes a high-tech portfolio with some non-tech companies. 

CEF Risks

Closed-end funds offer many benefits to their investors but also come with risks. To minimize potential mistakes, let’s review possible risks and learn how to address them.

High Level of Leverage

There is no sweet spot for a debt ratio, as an individual investor needs to choose between a level of uncertainty and return. Leveraging can be a way to boost profits and to provide higher performance, and it can also increase the risks. If an ROI is less than the borrowing cost, then the CEF will lose some of its net asset value.

As we mentioned earlier, The Investment Company Act of 1940 limits a company’s risk of loss by setting the maximum debt ratio.

A company with less debt may be in a better position for a market downturn. During the 2007-2008 financial crisis, CEFs fell deeper than the market, and it took longer to get back up. At the same time, CEFs continued issuing the promised dividends to their stakeholders.

Lower Liquidity

CEFs are relatively less liquid than ETFs or mutual funds due to the limited trading hours and fixed number of shares. But the publicly traded CEFs are still highly liquid and less risky than stocks. 

Portfolio diversification reduces liquidity risks.  A liquidity risk should be addressed only if a big part of your investment portfolio is not liquid.

Sensitivity To Interest Rates

An interest rate may impact the cost of a CEF’s debt, which it uses to buy securities. The fluctuation of the income impacts the fund’s overall profitability. Usually, the interest rate risk is more notable for longer-term or fixed income securities. The risk can be minimized by investing in unleveraged CEFs, which can protect your investment from a market downturn.

When To Buy CEF Stocks

Investors have two main options for when to purchase CEF shares: at its initial public offering or on a secondary market after the IPO.

• Buying CEFs at IPO: There is a higher risk of investing at the fund’s IPO, and you must also meet specific broker requirements to be eligible. IPO valuations are highly speculative. If an IPO is overvalued and the price is set too high, the fund may trade at a much lower level than its IPO price. It may take longer to return to its initial price.
• Buying CEFs on a secondary market: Based on current market supply and demand, a CEF’s market price can be higher or lower than what the portfolio is worth. When you buy CEFs at a premium, you are paying more than the portfolio assets are worth. When you buy them at a discount, you pay less and expect that the CEF’s price will increase. You will need to look at the fund’s past performance to judge whether or not the price premium is worth it.

Buy Closed-End Funds for Your Retirement

Closed-end funds can help you further improve your investment portfolio through increased portfolio diversification, stable passive income, and high yields. When managed by successful investment gurus, CEFs provide safe payouts. Look for funds that are still undervalued and may provide solid entry points, making them good long-term holdings for a portfolio.

You need cash to retire — and to stay retired. CEFs are one of the dividend-paying investment vehicles that can help you pay the bills. Subscribe to Investors Alley’s “Dividend Hunter” newsletter to learn which stocks could be the backbone of your retirement.