Five Key Considerations For Investing in CEFs

If we had to choose one word to describe the closed-end fund market during the second half of 2007, it would be "tumultuous." Following a first half during which we saw record closed-end fund issuance ($24.29 billion, 28 IPOs), the market struggled during the second half, both in terms of new issuance and secondary prices. There seemed to be more than enough blame to go around for the downturn, ranging from the credit crisis brought on by the mortgage meltdown, to professional traders who—because of recent dislocations in the market—were forced to liquidate closed-end fund positions, to fourth-quarter tax selling by retail investors looking to realize losses before year-end. At least the start of the new year removed this final negative catalyst from consideration.

So as an investor, what should be your first move in 2008? Ask this question to those who participate in this market daily and you are liable to get many different answers. Regardless of the answer, the recent price declines in closed-end funds may present an opportunity. Before dipping your toe in the water again, you should evaluate your current holdings before adding other names.

How a Closed-End Fund May Fit in Your Portfolio: Five Key Considerations

Volatility in share price is not a foreign concept to investors who have participated in the closed-end fund market over the years. As you review your portfolio at the start of 2008, consider the following regarding your existing closed-end fund investments:

1. Reason you bought the fund. Whether it was five months or five years ago, you added a closed-end fund to your portfolio for a specific purpose. During volatile times, it is important to recall the reason why you added the fund to your portfolio. This will help you avoid knee-jerk reactions that you might later regret.
2. The strategy the fund employs. There is an old saying: "Closed-end funds are sold, not bought." This statement speaks to the fact that many retail investors don't understand the funds they own in their portfolio. Having a firm grasp of what the fund is designed to do will, again, help instill confidence in your holdings.
3. The fund's fit into your asset-allocation strategy. It is important to remember that a closed-end fund is a structure—not a strategy. Closed-end funds can offer investors access to different underlying securities and asset classes. In the last 20 years, income has been a dominant reason for owning a closed-end fund. It is important to note, however, that not all funds are designed strictly for income. Over the past few years, sponsors have increasingly focused on total return in an effort to meet changing investor needs. Take the time to look under the hood of your fund to determine how it fits into and contributes to your asset-allocation strategy.
4. The fund manager's ability to deliver on their objective. All too often, closed-end fund investors focus strictly on share price performance, rather than net asset value [NAV] performance. We understand this mindset, but for long-term investors it is imperative that NAV performance be factored. We believe NAV returns are the more appropriate measure of a manager's performance and ability to capitalize on opportunities over time. While many managers may promise a great "yield", it is important that they deliver on this commitment over the long haul. Today with the advent of managed and level-rate distributions, managers who are missing their income targets are resorting to returning principal as a stop gap due to poor performance. This is not to say that a return of principal should always be viewed as a negative; rather, it is to say that you should understand what you are getting paid. If your distribution rate exceeds the fund's NAV return, find out why. It could be a sign that the manager is making short-term comprises (to prop up "yield") at the expense of the portfolio's long-term well-being.
5. Your reaction to volatility in the closed-end fund market. Do you view volatility as a doorway to opportunity, or does it immediately cause you to second-guess your investment in a closed-end fund? The answers to this question will differ with each individual investor.

Viewing the Recent Weakness in Closed-End Funds as an Opportunity

After a review of your closed-end fund holdings, you should now be equipped to better determine where you want to participate in the closed-end fund market.

Seldom are investors presented with the range of opportunities that the closed-end fund market offers today. However, it is important that you answer the following five questions when looking to add a closed-end fund to your portfolio:

1. Why would I buy a particular fund?
2. Do I understand the strategy the fund employs?
3. Does the fund fit into my asset allocation?
4. Has the fund manager delivered results?
5. How will volatility affect my attitude about owning this fund?

The answers to these questions should go a long way in helping you make an informed investment decision.

Remember, it isn't just about yield and discounts!