When I talk to investors, I often find that one of the most misunderstood investments is that of “closed end funds” (CEFs). While investors fundamentally understand the ins and outs of mutual funds, CEEs don’t. The problem is, they can be confused with mutual funds or exchange traded funds (ETFs) because they also hold a portfolio of stocks and bonds. However, their operation and their risks can be very different.
Let’s understand these differences.
Mutual funds continually sell and buy back stocks at the actual value of the underlying portfolio. This is not the case for CEFs; they sell common stocks once and don’t buy back stocks. Shares are traded on the stock exchange at the price set by supply and demand. This price may have little to do with the actual value of the underlying portfolio. Thus, CEFs are like ETFs which also do not continuously buy and sell stocks directly to investors. However, unlike CEFs, ETFs have a complex share buy / create function, which generally ensures that the share price stays close to the actual value of the underlying portfolio.
Another key difference: Mutual funds are only valued once a day, at 4 p.m., while CEFs and ETFs are valued continuously. However, ETFs and CEFs also publish the actual value of the underlying portfolio on a daily basis.
While CEFs sell common stocks once, they can sell preferred stocks and issue long-term debt. Those who use these funds to buy more underlying assets and thus leverage their portfolio. This increases the risk and possibly the return. Mutual funds and ETFs cannot issue preferred shares. While some ETFs use debt to leverage their portfolios, mutual funds are more constrained. The leverage comes in another way; mutual funds cannot be bought on margin while CEFs and ETFs can. Additionally, mutual funds cannot be sold short, unlike ETFs and CEFs. The latter two are also allowed to have options listed while mutual funds cannot.
CEFs have more flexibility than mutual funds and ETFs to hold unlisted or illiquid securities; that is, those that possibly cannot be sold quickly at a price close to what the fund claims they are worth. This flexibility can be a mixed blessing, as the actual value of the illiquid security could differ significantly from the CEF estimate. The management fees of CEFs are higher than those of ETFs, and often higher than those of actively managed mutual funds.
Why might an investor consider CEFs?
Since CEF prices vary from the actual value of the underlying portfolio, it is not difficult to find a CEF investing in the securities that an investor is interested in, selling for less than the value of the underlying portfolio. . This means that an investor could pay less than a dollar for every dollar of assets.
CEFs are complex investments which, due to leverage, may involve hidden risks that are not obvious to a typical investor. While they may offer the possibility of higher returns, they require careful analysis and a tolerance for potentially higher volatility. Additionally, investors should carefully analyze these “higher returns” because sometimes, especially for income-oriented CEEs, these returns may be in part a return of investors’ capital, and not actual investment profits.
All data and forecasts are provided for guidance only and do not constitute an invitation to buy or sell any security. Past performance does not represent future results. If you have a financial issue that you would like to see covered in this column or have any other comments or questions, you can contact Robert Stepleman c / o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl @ tampabay. rr.com. He provides advisory services through Bolton Global Asset Management, an investment adviser registered with the SEC and associated with Dow Wealth Management, LLC.