If you’re like most investors, you probably know little or nothing about closed-end funds. But you should. They offer advantages over conventional mutual funds. I’ll explain why, and then give you some names to consider.
Closed-end funds are similar to conventional managed mutual funds, but with one major difference: rather than selling and redeeming shares as needed, closed-end funds sell a fixed number of shares via an initial public offering (IPO). After that, the fund trades just like a stock. Buyers must purchase from existing shareholders, and shareholders must find a buyer if they want to sell.
Fund Investors: Buy High - Sell Low
To appreciate why that’s important, you have to understand a little bit about the psychology of the typical mutual fund investor.
Research shows that most investors pour money into mutual funds long after the market has started to move up. Since mutual fund managers must deploy the new money, they are forced to buy stocks that have already scored big gains.
Conversely, many investors sell their mutual fund shares after the market has suffered a big drop. Thus, fund managers must raise cash to redeem fund shares by selling stocks that are likely trading near their lows.
Bottom line: mutual fund investors force funds to buy high and sell low.
Two Major Advantages
But closed-end fund managers don’t have that problem. Except for portfolio gains and/or losses, they have a fixed amount of money to invest. Thus, they can make investment decisions without worrying about raising cash to redeem shares, or finding places to invest unexpected new cash. This stability seems to lend itself particularly well to funds that focus on dividend paying investments.
Here’s another advantage of closed-end funds. A fund’s net asset value (NAV) is the value of its total assets expressed on a per share basis. For instance, if a fund had $5,000 of assets and 100 shares out, its NAV would be $50 per share. Because they create or retire shares as needed, conventional mutual funds always trade at their NAVs.
But that’s not true for closed-end funds. Since share prices reflect the balance of supply and demand, closed-end funds rarely trade at their NAVs. Instead, they trade either above (premium) or below (discount) their NAVs. The good news is that most funds trade at discounts, typically 5% to 15% below their NAVs. That’s especially important for dividend fund investors because you can get $100 of income producing assets for $85 to $95.
High Dividends at a Discount
Dividend yield is the annual dividends you receive divided by the price you paid for the shares. For instance, your yield would be 10% if you pay $10 per share and receive $1 in dividends over the next 12-months.
In the world of closed-end funds, unusually high dividend yields or discounts to net asset value often signal bad news on the way. With that in mind, I recently ran a screen looking for closed-end funds trading at modest 6% to 12% discounts and paying dividends equating to 7% to 12% yields. More than 30 funds passed those tests. Here are the five that looked most interesting to me.
• BlackRock Strategic Bond (BHD) holds mostly below-investment grade (junk) rated corporate bonds. Two years ago, I wouldn't have touched junk-rated bonds. But now, with corporations of all stripes raising cash at will, I don't see much risk here. BHD is trading at a 6% discount to net asset value and pays monthly dividends equating to a 7.6% expected dividend yield.
• GDL Fund (GDL), formerly Gabelli Global Deal, primarily invests in arbitrage transactions related to corporate mergers, and to a lesser extent, corporate reorganizations and spin-offs. It’s trading at a 12% discount and pays quarterly dividends equating to a 9.5% yield.
• Madison Strategic Sector Premium (MSP) holds mid- and large-cap U.S. stocks, and employs a covered call strategy to generate income. It’s trading at a 10% discount and paying quarterly dividends equating to an 8.3% yield.
• Nuveen Diversified Dividend & Income (JDD) holds a mix of dividend-paying stocks and corporate debt (non-investment grade). It’s trading at a 7% discount and paying quarterly dividends yielding 8.5%.
• Zweig Fund (ZF) holds mostly large-cap U.S. stocks. It’s trading at a 9% discount and paying quarterly dividends yielding 11.1%.
While these funds looked good to me, they may not suit your investing needs. So, do your due diligence. The more you know about your investments, the better your results.