Open Your Portfolio to Closed-end Funds

Physician's Money Digest, December 2005, Volume 12, Issue 16

More recently, closed-end funds (CEFs) have gained popularity. The history of CEFs begins in 1893, more than 30 years before the first mutual fund was formed in the United States. Currently, there are more than 500 CEFs, some of which have histories that date back more than half a century.

Following an initial public offering, a fixed or constant number of CEF shares are traded on stock exchanges such as the AMEX and the NYSE, although some CEFs do not trade on an exchange at all. Intraday trading allows investors to purchase and sell shares of CEFs just like the shares of other publicly traded securities, typically in relation to, but independent of, the NAV. Transactions are based on the market price as determined by the forces of supply and demand, and transaction prices include a customary brokerage charge. Best of all, CEFs do not impose minimum purchase amounts, unlike most mutual funds.

Interestingly, the price of a CEF may be above (sell at a premium to) or below (sell at a discount to) its NAV. The invested capital in a CEF is fixed and will change only at the discretion of management. Capital is increased through the issuance of shares in conjunction with a rights offering or through the reinvestment of certain dividends. Capital is reduced when shares of the fund are repurchased with a stock repurchase program or tender offer.

Just like OEFs, CEFs offer diversification, professional management, convenience, and liquidity. The following are some of the advantages CEFs offer that conventional mutual funds do not:

•Discount opportunities. When CEFs can be bought at a discount to their NAV, investors are buying a dollar's worth of assets for less than a dollar. This can be attractive for obvious reasons. With income-oriented funds, the yield will be higher when calculated on actual dollars invested at a discount compared to the NAV. For example, suppose the NAV of a fund is $10 and the annual yield based on NAV is 8% (ie, the fund generates $0.80 each year). If the fund currently has a market price of $19 (selling at a $1 discount to its NAV), the yield is not 8%, but 8.9%. So, if you had purchased the fund at $19, your realized yield on the fund is 8.9%, not 8%.

•Portfolio management. CEF managers are responsible for a stable pool of capital and do not have to worry about the constant inflows and outflows of cash that mutual fund managers must worry about. They also do not have to worry whether their fund will have enough liquidity to pay back investors who suddenly sell or redeem their shares. Regardless of trading volume, CEF managers are not forced to sell securities in a declining market to meet redemptions.

•Price control and timing. CEFs allow limit orders (buying or selling a security at a specific price) and stop orders (buying or selling a stock once its price reaches a specified price) to be placed, since orders can be executed throughout the trading day. This is not possible with a mutual fund, because all orders are placed at the close of the business day.

•Leverage potential. CEFs may issue preferred stock or debentures or borrow money to leverage their investment positions, which allows managers to enhance yield. However, this practice can also be a double-edged sword, since leverage can add to price volatility and increase risk, especially in a rising interest rate environment.

•Commissions. The only transaction- related costs are commissions to buy and sell funds. CEFs do not impose trail commissions or 12b-1 fees, which are assessed against mutual funds annually.

•Lower expense ratios. CEFs do not incur ongoing costs associated with distributing shares, as do many mutual funds; thus, the expense ratio of CEFs may be less than those of mutual funds.

As with OEFs, there are a variety of offerings. Bond funds account for nearly two thirds of all the capital at work in CEFs. The most popular categories of CEFs are the following: municipal bond funds; taxable US bond bunds; diversified US equity funds; sector and specialty funds; global and international funds; and single country funds.

Investors also must be aware that, as with any investment, there is risk associated with buying and selling CEFs. Some of the risks specific to CEFs that must be examined are credit, interest rate, leverage, currency, and politics (especially when examining single country funds).

Thomas R. Kosky and his partner, Harris L.

Kerker, are principals of the Asset Planning,

Group, Inc, in Miami, Fla. The company specializes

in investment, retirement, and

estate planning. Mr. Kosky also teaches corporate

finance in the Saturday Executive and Health Care

Executive MBA Programs at the University of Miami in Coral

Gables, Fla. Mr. Kosky and Mr. Kerker welcome questions or

comments at 800-953-5508 or e-mail Mr. Kosky directly at

ProfessorKosky@aol.com.