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Today’s retail income investor has lots of risk on the table. Much like walking into a minefield, you do not know you are in trouble until it’s too late and you are right in the middle of it. What has happened is that the average retail income investor was forced out of the relative security of CD’s and Government bonds in search of yield.
With the U.S. Government holding rates at historically low levels, anyone needing yield to survive is being pushed into the riskier assets that the market has to offer. Our retail investor, trying to complete their research, gets hit with an endless barrage of articles and research listing the top yielding equities. For the uninformed income investor it’s like being a kid in the candy story as there are never-ending possibilities of investments with outsized yields.
As a result, some income investors start buying into Closed End Funds (CEFs). Most will attempt to diversify into different types of funds in an effort to establish some protection, but most never really understand the risks and therein lies the problem.
Many income investors come in with the mentality that they used when investing in CDs and Government bonds. That mentality is to just sit and hold the investments, regardless of changes in price or external factors, to simply collect the yield. This philosophy might work well in highly rated bonds and CDs but will be disastrous in the world of CEFs. This article will not be able to cover in any great detail all of the risk factors, but here is a taste of what each income investor should have a basic understanding of, as well as beware of, in the world of CEFs.
What Are Closed End Funds?
CEFs are traded on a stock exchange like any stock. There are all different kinds of CEFs so we will concentrate on the income related ones. They can be made up of a wide variety of investment vehicles to provide income, for example they might contain a portfolio of stocks, bonds, and options to closely track a particular index, sector or group. Some of the more popular CEFs are Eaton Vance Tax-Advantaged Global (NYSE:ETG) and Zweig Fund (NYSE:ZF). These funds currently offer outsized yields which will be attractive to income investors. The problem here is that the income investor will be attracted to the yield first and will commit little time to the inner workings of the fund. Here are some risks that all investors need to be aware of in the CEF world.
Leverage
Several funds will issue preferred shares or even borrow more money and take on debt against the fund to further "juice" the yields for shareholders. Needless to say, changes in interest rates and market conditions can play havoc on those CEFs leveraged up to very high percentages. A fund that is leveraged up to extreme levels is obviously not going to react well in share price as a rise in interest rates takes hold. For example, consider a fund like Eaton Vance Short Duration Diversified Income Fund (NYSE:EVG). The Fund seeks high current income and capital appreciation through investment in senior secured floating rate loans, bank deposits denominated in foreign currency and US backed mortgage backed securities. The fund yields a nice 6.6% yield which would attract any investor. Look a little deeper and one will notice the fund is leveraged up to 56% which is rather high. So is EVG a good or bad investment? That depends on your views of what the future might hold. If interest rates stay low for an indefinite period then it might be fine. On the other hand, if we are to get a meaningful upward move in rates then EVG shareholders might not come out on the winning side.
Payouts and Return of Capital (ROC)
Several funds will also make managed payouts where the fund’s management will determine how much is paid out to investors. The problem could be that the fund has not generated enough earnings to cover the distributions, so management makes a decision to return the investment capital instead. On the surface the yield seems fantastic, but if the fund is only distributing the capital then this could be a bad sign as the fund is failing at its mission to generate income.
Therefore, return of capital (ROC) must be analyzed for each CEF. It should be noted that ROC is not necessarily a bad thing. For example, if a fund is deriving its dividend via writing LEAP options, it might not be able to complete the trades in time to get the funds into place for distribution. The fund will want to show a stable dividend, so they might use ROC until such time that the option trades clear. An example of a CEF in this arena is the Gabelli Global Gold, Natural Resources and Income Trust (NYSEMKT:GGN). GGN is a closed ended equity fund launched by GAMCO Investors, Inc. and managed by Gabelli Funds, LLC. The fund is an income investment that happens to be using gold, silver, and natural resource stocks to derive income off the selling of covered calls.
Another example of ROC not being a negative issue is if a fund has holdings that have greatly appreciated in value but the manager does not want to liquidate them, yet at the same time needs to make a distribution. In this case the fund might dip into its cash reserves. Usually analyzing the NAV in comparison to the distributions can often highlight if the current yield is a distribution of unrealized capital gains or something more concerning. In the end though, the income investor needs to analyze the actual source of the dividends they are receiving.

Net Asset Value ((NAV))
Finally, one other risk to be aware of deals with the net asset value (()) of the fund. CEFs tend to be actively managed and therefore can and will have all kinds of strategies and unique investing practices in place. That means that holdings of a CEF are often unknown to the investing public at all times. That being the case, CEFs will often trade in a wide range when compared to their NAV.
The range will vary all over the board from steep premiums to bizarre discounts. For example consider the Kayne Anderson MLP CEF(NYSE:KYN). KYN is a CEF that seeks a high total return through investments in energy related MLPs and other industrial transport companies. The current yield is 7% and that number will certainly attract investors.
If not careful though, one could end up paying far more than the CEF is actually worth. At one point during this 52 week cycle KYN was trading at a 15% premium to NAV. That is a pretty steep premium to NAV and anyone not paying attention could have easily overpaid as the NAV now is closer to 6%.
Another example is the Gabelli Utility Trust fund (NYSE:GUT). GUT is a fund that seeks long term capital growth and income through investment in companies that provide products, services, or equipment for the generation or distribution of electricity, gas and water. The fund is currently yielding 9% which is guaranteed to attract some attention.
On closer inspection however, one sees that the fund is selling for a 30% premium compared to its NAV. So the question to ask is, are you willing to pay a 30% premium on the NAV to own the CEF. The answer, of course is, it all depends on the individual investor.
On the other side of the spectrum, CEFs can also start to trade at steep discounts to their NAV. It’s not hard to imagine an income investor buying a CEF at par to NAV, only to see it trade at a steep discount for no apparent reason. Needless to say the demand for shares of the CEF will drive the price. If the income investor is not keeping an eye on the fund and its characteristics then losses can and will occur at some point.
Listed above are just some of the risks that a new, high yield CEF investor must face. Simply buying high yield investments based upon yield alone is setting oneself up for disaster. If one is going to venture into this type of investing, make sure to have a firm grip on the risks at hand.

Disclosure: I am long GGN.
Source: A Primer On Risk for the Closed End Fund Investor