An Introduction to Closed-End Mutual Funds

Income-oriented mutual funds are not risk-free, but they provide a safer start for people looking for high yields, without the time commitment or risk that comes with individual securities. There are two types of mutual funds, open-end and closed-end. And, due to their differing structures, they offer different advantages and disadvantages. 

As an investor looking for investment income, the closed-end option is generally the better route. In this article, we'll discuss closed-end funds and give you seven tips on how to use these funds to increase your investment income.

An Open and Closed Case

In an open-end mutual fund, shares are issued and redeemed daily by the fund's sponsor (the issuer of the fund). By design, these funds are always traded at their actual cash value, also known as net asset value, or NAV, which is calculated on a per-share basis before sales charges are applied. Moreover, while this is the most popular type of fund, it is not necessarily the best for those seeking income.

On the other hand, closed-end mutual funds, which generally provide more income to investors, issue all of their shares on the first day the fund opens to investors, instead of issuing and redeeming new shares every day at their NAV. After that, the fund's market value can move just like an individual stock, free to rise and fall above and below the actual cash value of the shares. The fund's sponsor does not issue or redeem any new shares on a daily basis. Instead, shares trade between other investors independent of the NAV.

And while these shares can trade at a premium to their actual cash value or NAV, they usually trade at a discount (ranging from 2-3% on the low end, to 15-25% on the high end). This discount can mean a lot for investors looking for a cash yield from these funds as the yield rises considerably when underlying assets are trading at a 25% discount.

Example of a Closed-End Fund

Suppose that an open-end income fund is opened to investors and issues 10 million shares at $10 each, raising $100 million for the fund, which it subsequently invests in securities yielding 7% annually, or 70 cents per share in income, which in turn is paid out to investors. Now imagine that a closed-end fund issued the same number of shares at the same price, but after it opened to investors, the share price of the closed-end fund fell to $8 while the NAV (cash value) stayed at $10. This represents a 20% discount, and the dividend, which started at 7 cents, and was originally a 7% yield is now providing a yield of 8.75% ($0.70 / $8.00 = 8.75%). This is a much better yield than the 7% and represents a major potential advantage between an investment in a closed-end fund and one in an open-end fund. Note that investors were better off buying the closed-end fund after the discount to NAV moved to 20%.

7 Tips for Closed-End Fund Investors

For investors looking for cash yields from their investments, closed-end funds present a viable alternative to owning individual securities or open-end funds. Nevertheless, "caveat emptor" is the rule here. Let's take a look at seven tips to help you increase your cash yields with the closed-end funds.

1. As a rule, never invest in the initial offering of a closed-end fund since the discount to its NAV usually falls after the fund is opened to investors. Also, don't buy closed-end funds trading at a premium. That is like buying a dollar for $1.10.
2. Closed-end funds, which are often designed for income, will commonly employ leverage to enhance their yields. With this extra leverage comes additional risk. Remember the old adage, "out of debt, out of danger." That applies even more so when you're talking about borrowing at 5% in order to invest for a 7% return. There is just not much room for error, so watch out for the debt levels of your funds. Debt-to-total assets ratios above 40% should be considered a red flag.
3. Open-end funds always trade at NAV, but usually do not deliver a high yield to investors because they typically focus on capital gains, not income. Closed-end funds are more likely to invest in income-producing assets than open-end funds, but the discount to NAV can rise (price falls versus NAV) after you buy the shares. Investors should consider this additional risk.
4. Unlike common stocks that may raise dividends on a regular basis, income funds rarely raise their dividends and, historically, are more likely to cut their dividends than to raise them. This is because funds tend to invest in fixed-income securities, such as bonds and preferred stocks that may never increase their income payout.
5. While you may get diversification from a fund, you may also get lower income due to excessive management fees. More than 1.2% is a danger sign, especially for an income fund, and .75% is much better. When trying to find yield-producing funds, look for a 7% annual yield (or a couple of percentage points over U.S. Treasuries), or a discount-to-NAV of over 10% (unless it's a low-risk bond fund). When the yield is over 10%, you should make sure that it isn't a one-time payout or capital distribution. It isn't likely that you will see a fund paying out more than 10% in yield that is backed by income. The exception to this is if you are looking at a fund in a distressed area. For example, a global equity fund during a time of financial crisis.
6. Payouts of interest and dividends are what we want. A payout of capital is little different than selling some of your stocks and calling it a cash yield. You'll see a higher percentage of closed-end funds invest in bonds and preferred stocks than in the open-end fund space. These types of investments typically provide higher yields than common stocks; however, they are taxed at the ordinary income tax rate of around 35%, as opposed to the dividend tax rate of around 15%.
7. Watch the actual payout of these funds and not just the annual yield. Sometimes the annual payout can be given all at one time; if this is the case, then it might not be an income fund at all but just look like one because it had a distribution of 6% to 9% at the end of the year. Instead, look for funds that regularly pay out a monthly or quarterly distribution and invest in income-producing securities. Usually, a fund will have the word "income" or "dividend" in the name if it is, in fact, an income fund. If it's not an income fund, then save the money that you'd spend on management fees, as you could own an index fund for much less and sell off shares as you need the income. Read the 10-K to find out which kind of distribution it really is, or check with your brokerage firm or tax advisor.

The Bottom Line

There are good funds out there if you will take the time to find them. After you look around for a while, you will start to get a feel for the better funds to suit your situation.