Low saving rates have forced people to look for other options to help them improve their returns, and funds have become more popular for individuals looking to get started in the investments niche. Are you willing to buy closed-end funds, and do you want to understand what’s involved? Read on to find out.
We understand that there’s a substantial risk when investing closed-end funds, and often, you may get less than you invested. This is where we come in. Our article is meant to provide you with more insights, tips, and tricks for investing. We’ll help you gain a basic understanding of the differences between buying shares in a closed fund and buying shares into a fund so that you get to understand which of the two would be better for you.
Our article covers various factors in closed-end funds, including:
- Defining what closed funds are
- Looking into whether it will be worth it for you to buy closed funds
- Defining the risks of closed-end funds
- Defining whether closed-end funds pay dividends
What is a fund?
A fund is defined as a pool of money allocated for a specific purpose and can be established for various purposes. Professionals often manage and invest the pool of money invested in a fund within a particular termination period. Investors who own shares in the fund receive a cash payment equal to the NAV per share whenever the fund’s termination period reaches.
A CEF or Closed-end fund is a form of mutual fund with which investors pool their money which is overseen by a professional money management team that selects the underlying bonds, stocks, and various other securities. A CEF is an indirect pooled investment vehicle and is often found in multiple employer-sponsored and well-defined contribution plans like 401(K) in the US.
Investing is quite different from putting your money in a bank where you are guaranteed an interest. It is less secure, i.e., a gamble, and your money can either go up or down. However, it could be an excellent way for you to get more returns if it pans out. Read on to find out your options and decide how you could go about it.
Are Closed-end funds worth it?
Closed-end funds could be worth it; however, they are less popular. They trade on the stock exchange during the day, much like ETFs plus, they can also use leverage, which could lead to greater rewards or more significant risk. However, one issue with closed-end funds is that they tend to be less liquid when compared to open-ended funds. If you want your investment back, then you’ll have to trade your shares on the market often with a discount.
Closed-end funds have been available since 1893, 30 years before open-end funds were introduced. However, despite their head start, they are still outnumbered by open-end funds. This is because closed-end funds tend to be more volatile, less liquid, and complex compared to their counterparts. They are often considered to be a tool often used by relatively sophisticated investors.
Why are closed-end funds bad?
Various reasons make closed-end funds bad for investment. One of these reasons is that closed-end funds managers often take advantage of investors using their closed-end fund structures to charge high fees from their investors. These fees are often collected through the initial offering fees, the egregious management, and paying commissions to your broker when you’re buying or selling shares. This is why most of these CEFs often trade at huge discounts to the funds’ net asset value.
The key to benefiting from considerable is through prudent research and investing in CEFs that trade at discounts from their net asset values, compensating for the CEF’s management fees. This way, you won’t have to risk losing more cash due to managerial expenses.
However, that said, long-term investment in CEFs requires discipline, patience, and a greater understanding of determinants of discounts and whether or not you should buy the shares. You’ll also have to weigh between the CEF’s investment potential and expenses to determine if your investment will be worth it.
CEFs are hard to research
CEFs are harder to research compared to open-end funds, and it may take you some time to figure out what that particular CEF invests in that helps them generate the huge dividend that pulled you in. Dividends paid by CEFs could be a return of your capital, or they could be from interest. Either way, analyzing where your pay put comes from could help you understand whether your investment will be worth it.
You’ll also need to analyze whether the market price of the CEF is lower or higher than the NAV or net asset value. This could help you know if and when to buy in. you’ll also need to know the average share price discount or premium and the factors that could make it change.
Can you invest in a closed-end fund?
You could easily buy closed-end funds through your brokerage account the same way you could buy dividend stocks. Select the type of CEF you want and use various filters through helpful metrics like standard deviation, fund manager tenure, premium/discount, and more.
You may notice that analyzing CEFs is much more challenging than analyzing open-end funds. For instance, there aren’t any financial statements that you could study to get a clearer picture of whether investing in a particular fund will be profitable.
You’ll need to ask yourself how the fund invests, whether their shares are cheap or expensive compared to their NAV (net asset value), how much financial leverage the fund uses, the CEF’s management fees, etc.
Finding satisfying answers to these questions will aid in making the right decisions and investing wisely.
When should you buy closed-end funds?
You can buy closed-end funds at any time of the day whenever the market is open. However, we understand that you are more interested in the best period to purchase closed-end funds. The best time for you to buy closed-end funds is when the shares are sold at a discount to their NAV (net asset value). CEFs often trade at discounts, which often get wider in volatile markets.
This makes it cheaper for investors to purchase shares priced way below the NAV. However, you should note that this is a risky strategy where the buyer assumes that the fund’s discount will narrow down through the investor’s timeframe. The assumption also ignores the primary contributing factor affecting CEF returns, distributions.
What are the risks of closed-end funds?
While closed-end funds often offer better income potential, it’s always good for you to ensure that you are aware of some of these risk factors:
Price vs. NAV
A fund’s NAV refers to the value of its combined underlying holdings and is often different from the fund’s price share. This could prove profitable or costly depending on various factors, including market condition, investor sentiment, and the fund’s performance.
More than 60% of CEFs use financial leverage, and this magnifies the returns positively or negatively. Funds with more leverage are more likely to be whipped around more than the others, and they are more likely to experience more significant investment losses or gains.
Please understand how your fund determines distribution amounts that are paid out. This information is more likely to be found in the fund’s prospectus. If the fund uses its capital to partly fund the distribution, it would be good to determine why this is happening and why the fund isn’t generating enough income.
It’s also good to be aware that current distributions may change positively or negatively depending on various factors, including market value. For instance, if the market value drops significantly, then the chances are that your distributions will be adversely affected.
CEFs often have much less liquidity than open-end funds, stocks, and ETFs since they are a much smaller asset class. This means that it would be harder for you to buy and sell CEF stock at preferred prices, and this depends on the number of people willing to take the other end of your bargain.
It’s good to note that premiums and discounts are often more volatile during times of market duress. Keep this and all other risks in mind whenever you browse through high-yielding CEFs. Note that their distribution rates aren’t guaranteed, and often, they aren’t the same as their total return potential.
Do closed-end funds pay dividends?
CEFs pay dividends either monthly or quarterly. You could get higher dividends depending on the state of the market. For instance, if the market is rising, you are likely to get higher dividends; however, if the market is falling, you are sure to get lower dividends.
The potential for higher dividends attracts most investors to closed-end funds, but you have to note that it’s a high-risk investment because of the leverage the funds use plus their structure. CEFs are ideal for savvy individuals who can have enough money to buy the shares and whether any unfortunate losses.
Investing in closed funds is a great idea and, often, it produces better results and higher dividends than most other types of funds. However, you’ll have to take some time, do some research, and work on finding the best CEF fund to invest in. Understand that there’ll be lots of risks but also lots of rewards if everything works right. Have fun investing!