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With the recent need for income-producing investments, income oriented closed-end funds are one type of investment product that has garnered a lot of attention lately.  While there is nothing inherently bad about closed-end funds, they are complex products that without proper understanding by an investor can be very, very risky investments. Many income oriented closed-end funds have historically been viewed as safe, mostly fixed investment vehicles.  Due to the current economic environment, though, it is important to have an in depth understanding of how closed-end funds work and the volatility that may accompany them.

Q: How does a closed-end fund compare to an open-ended mutual fund?

A: A closed-end fund is very similar to an open-ended mutual fund except that they do not issue redeemable shares.  Closed-end funds have a fixed capital structure, meaning they can only issue a certain number of shares.  Once the total fixed number of shares are sold in the primary market, they trade in the secondary market based on supply and demand.

Since prices are set by supply and demand, it is possible for the shares to sell above or below the Net Asset Value (NAV)*.  In comparison, shares of an open-ended mutual fund do not sell for more or less than their NAV because shares are created and redeemed daily.

Q: What are the implications of this “set” number of shares?

A: Because the number of shares is fixed, the fund’s market value can stray from its NAV, rising or falling below the actual cash value of the securities held within.  This means, then, that the fund can be sold at a premium price (above the underlying securities’ NAV) or at a discounted price (below the underlying securities’ NAV).

Q: How are so many large, established closed-end funds able to present themselves as “fixed” products, with guaranteed income and/or a monthly or quarterly pay out?

A: They can make these claims with a few asterisks attached, and it is four main asterisks that are crucial to understanding the risks associated with closed-end funds.

1)      Leverage

a.       Some closed-end funds will employ leverage, or borrowing, to achieve a certain return or income rate. In declining and low interest rate environments, leverage can work out favorably and magnify the fund’s gains.  Therefore, although not implicitly bad, in increasing and high interest rate environments, leverage could cause funds to owe more than they are making and ultimately lose value.  As is the case with anything else, borrowing to increase returns is inherently accompanied by more risk.  In conclusion, leverage is a component of closed-end funds that can make them extremely volatile (and hence, risky).

EXAMPLE: When there is leverage things go wrong much more quickly. In a "normal situation,” if you own a stock and it goes down 10%, you are left with 90% of your assets.  In a 100% leverage situation, if you own a stock and it goes down 10%, your whole portfolio goes down 10%, but netting out the 100% that is borrowed, you are down to 80% of your original investment.

2)      Liquidity

a.       Closed-end funds, on their surface, may seem to guarantee income, but it may be attempting to sell the fund that causes problems to arise. When selling a closed-end fund, the salesman notes that a fund bought at a discount will not necessarily sell close to NAV.  In other words, a rise in price towards NAV should not be assumed in total return.  Because closed-end funds are composed of several securities, but are sold in their own secondary market, they are not the most liquid instruments.  Just because a closed-end fund is bought at a discount doesn’t mean that when the investor needs to sell the fund, he/she will make money buy selling it at NAV or a premium.  The price at which the closed-end fund will sell is determined by its perceived value in the secondary market, so if it looks undesirable to people, regardless of its NAV, it may only sell at a discount.  Therefore, closed-end funds are not devices that should necessarily be sold quickly because in illiquid environments, they can lose considerable value.

3)      Return of Capital

a.       Some closed-end funds that have a policy of a guaranteed monthly or quarterly pay out will not have made enough to be able to pay shareholders in interest earnings or dividends.  However, because the pay out is guaranteed, the funds will make up the difference in lack of distributions by paying out some of the money that investors have paid in.  This would undoubtedly have an impact on a shareholder’s total return, although it would not be evident based off just the monthly or quarterly payout sums.  Also, to generate more income, funds can sell securities (or make capital gains).  This is important to monitor, as it is not as reliable or sustainable for producing income. Therefore, it is very important with closed-end funds to monitor not just the payout rate, but the total return.

4)      High Fees 

a.       Similar to mutual funds, closed-end funds also have hidden fees that investors usually don’t consider.  Depending on the fund, it can be front-loaded, back-loaded, or not loaded.  A front-loaded fund means the investor is charged an upfront cost to own the fund, whereas a back-loaded fund will charge the investor a certain percentage to sell the fund.  Every closed-end fund has an annual expense ratio.  This annual expense is used to pay the third-party investment manager and is not directly taken out of your account but is reflected in the overall performance of the fund.  Some closed-ends funds are not overly costly with regard to fees, but it is certainly a factor every investor should consider when looking for attractive investment opportunities.

Q: Why might closed-end funds be particularly risky in the current economic environment?

A: There are many funds, especially right now, that employ very high premiums, as well as leverage. Currently, several income oriented closed-end funds have quite high premiums, given historical norms. While some funds may have been reliable in recent years, a shift in the economic environment could have a drastic impact on the fund’s value, and ultimately result in heightened losses, given the high premium and leverage factors.

*NAV: Net Asset Value is the fund’s price per share. It can be found by dividing the total value of all the underlying securities of the fund, less any liabilities, by the