Investors looking for better returns have rediscovered closed end mutual funds. "For people looking to enhance their returns, closed end funds are one of the key investment vehicles to do that," says Morningstar analyst Mike Taggart. But as with all investments, it's important to understand the performance details of a closed end fund before buying one.
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Many closed end funds, for example, are designed to produce regular payments to investors. These payments may be similar to a dividend but fund earnings don't always cover the full amount of such distributions, forcing fund managers to liquidate holdings. In effect, part of such a fund's distributions are a return of the investor's own capital -- hardly a cause for celebration. Yet Taggart says many investors don't appear to understand that a good part of their fund's performance may be nothing more than a return of their initial investment.
As their name implies, closed-end funds are mutual funds that raise money through an initial public offering and then are closed to new investments. If you buy $1,000 in a regular mutual fund, the fund will take your money and invest it in the fund's basket of holdings, raising the amount of net assets held by the fund. By contrast, if you buy a closed-end fund, your money is used to buy fund shares and has no impact on its assets. The value of your shares certainly reflects the underlying performance of the fund's holdings. But it also reflects many other factors, including the track record of the fund's performance and investor demand for the shares. Also, closed end funds trade like a stock, making them more attractive to many investors than traditional mutual funds.
Closed end funds, Taggart says, also enjoy more latitude than normal mutual funds when it comes to using borrowed funds and other tactics to increase the leverage of the fund's assets and boost returns.
Morningstar tracks about 620 closed end funds and Taggart says the sector has about $250 billion in total assets. The performance of closed end funds can be confusing to investors, he explains. Most market listings for the funds describe their returns as yields, he says, because that's how the listings software is set up. But that "yield" is technically a distribution rate, and includes a fund's net investment income, its realized capital gains and its return of capital to shareholders. This total is then divided by either its current trading price or the net asset value of the fund's investments. Calling this rate a yield implies that the fund has actually posted a rate of return. But if much of this rate comes from an investor's own capital, an investor may be mislead into thinking the fund is performing a lot better than it actually is.
[See Automatic 401(k)s Aid Retirement Readiness.] Still, Taggart says, it's those high stated "yields" that have drawn strong investor demand for closed end funds. "Return of capital is a huge issue in the closed fund world," Taggart says. "People see these yields and just flock to the funds. . . . If the yield looks too good to be true, it probably is too good to be true," he advises.
Taggart says there are three fundamental questions that should be answered before people buy a closed end fund.
1) What's the difference between a fund's market price and the net asset value of its holdings, and how has this ratio changed during the past three years? Many investors lock onto funds that trade for 10 or 15 percent less than the asset value of their holdings, he explains. They figure that over time the trading value of the fund will trend up to its net asset value, and the investor will enjoy that gain plus the actual earnings of the fund. But there are a host of reasons such discounts exist. What if the fund has steadily traded at a 10 percent discount and continues to do so, Taggart asks. Where's the investor's profit then?
Other funds may persistently trade at a premium to their holdings. This may deter some investors, he says, when the question they should be asking is what has happened to that ratio over time. For example, a fund with a 10 percent discount doesn't look so good if it turns out the discount used to be 15 percent. But a fund that trades at a 5 percent premium may be an attractive cyclical buy if it turns our its historical premium is 10 percent.
2) What's the distribution rate of the fund and what are the sources of that distribution, particularly capital returned to investors? In addition to understanding these components, there also can be adverse tax consequences of certain fund strategies. Taggart is particularly critical of closed end funds that focus on aggressive capturing of cash dividends from stocks. Such funds buy stocks just before the deadline to qualify for the next dividend. They then collect the cash dividend and immediately sell the stock, using the proceeds to execute other dividend plays. Taggart says it's simply not clear that such a strategy produces long term benefits to shareholders. But by being active traders and short-term owners of stocks, such "dividend capture" funds can generate big trading expenses and high tax rates on dividend revenues.
3) How much leverage did the fund use to generate its results, how much of this leverage was reported under SEC rules, and how much from the use of non-standard tools. Taggart says the Investment Company Act of 1940, a cornerstone of mutual fund regulation, requires the formal disclosure of only some of the leverage tools employed by closed end funds. "The rest is reported on their balance sheets," he says, "but many investors don't know what to look for or how to analyze the balance sheet."
The goal of leverage is to enhance returns, and Taggart notes that highly leveraged closed end funds have been performance stars so far this year. But leverage also raises the risk to shareholders, and they should be informed of how much risk they're taking on when they buy a fund. In fact, over a longer, three-year period, it's been the leveraged funds that have performed the worst. "The bottom performers are leveraged funds that were blindsided in the downdrafts of 2008," Taggart wrote in a recent Morningstar commentary. "Of the 619 closed end funds that we track, 446 utilize some form of financial leverage, 290 of these utilize non-'40 Act leverage, and 61 rely solely on non-'40 Act leverage."