What are Closed End Funds (CEFs)?
By Steve Selengut,
Professional Investment Portfolio Manager
since 1979,
BA Business, Gettysburg College; MBA Professional Management,
Johns Island, SC, U.S.A.
Sanserve [at] aol . com
www.sancoservices.com
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A Closed End Fund (CEF) is a publicly traded investment company
that invests in a variety of securities such as stocks, bonds, preferred
stocks, real estate, mortgages, oil and gas royalties, etc. The
variety of sectors, classifications, and geographical representation
is every bit as confusing as it is with traditional funds, but the
advantages are easy to understand.
Capital is raised by an Investment Company through an initial public
offering (IPO) of common stock and the proceeds are invested according
to the investment objectives of the fund. Like a traditional (open
end) mutual fund, a Closed End Fund has a board of directors, appoints
an investment advisor and employs a portfolio manager.
Unlike conventional mutual funds, CEFs do not issue and redeem
shares directly with investors at net asset value. CEFs are listed
on national securities exchanges, where shares of the Investment
Company are purchased and sold in transactions with other investors,
just like individual company stocks, and most often not at net asset
value.
Many Brokerage Firm Statements will list these securities as Equities
or Mutual Funds, not quite in sync with the purpose or nature of
the securities contained within. You should keep this in mind when
you analyze the asset allocation of your portfolio and adjust accordingly.
Although the number of outstanding shares remains relatively constant,
additional shares can be created through secondary offerings, rights
offerings, and/or the issuance of shares for dividend reinvestment.
Existing owners always get the first shot at new shares, in proportion
to their holdings, so they can choose to protect themselves from
any dilution of interest. Again, vastly different from traditional
mutual funds, where dilution is the very nature of the fund.
Many of the advantages of Closed End Funds are discussed below.
It should be abundantly clear that this form of investment has eliminated
nearly all of the drawbacks of conventional mutual funds. The two
have very little in common.
Trading Liquidity - Flexibility - Cost: Closed End Fund shares
may be bought or sold at any time during the trading day, just like
common stocks, and share prices will fluctuate. They are excellent
start up investment vehicles for smaller accounts where diversification
would otherwise be difficult to achieve.
There are no penalties for leaving the CEF when the stock is sold.
The only direct cost involved is the commission paid when buying
or selling the shares.
Leverage IS an Advantage: Closed End Fund managements borrow money
by issuing Preferred Stock in an effort to increase the productivity
of the investment portfolio.
As long as the short-term interest rates paid to the lenders and
the dividends paid to Preferred shareholders are lower than the
net long-term rates earned by the portfolio, the common shareholders
of the fund will earn higher rates that they would have without
the leverage.
Rising interest rates aren't nearly as scary as critics would like
you to believe. The manager can reduce the leverage, and new investments
are made at higher yields. All debt is a form of leverage and, without it, you would probably be peddling to work instead of driving that Mercedes.
Efficient Portfolio Management: Unlike open-end mutual funds, the
asset base for CEFs is relatively stable. Without the pressure of
constantly investing or redeeming securities based on investor demands,
CEF managers are in charge of the fund and use their own experienced
judgment to make investment decisions --- uninfluenced by the fear
and greed of "the mob".
Fund Expenses: Due to minimal marketing expenses and typically
lower turnover, CEFs have lower operating costs than traditional
mutual funds. (Closed End Funds rarely advertise and don't pay distributors.)
They trade like Common Stocks, with the normal variable expenses
that trading involves.
CEFs do not impose annual 12b-1 fees, as mutual funds do, BUT they
probably do pay the fund manager too much money. Still, if my Closed
End Muni Bond fund is generating 6%, in monthly installments, she's
earning it!
No Minimums: Because Closed End Funds trade on secondary markets
like other common stocks, there is no minimum purchase or sale requirement.
Investors may purchase or sell as little as they like. And don't
expect to receive a prospectus --- yet another benefit since such
documents are written in unintelligible legalese anyway.
Distributions: CEFs make distributions according to a prescribed
schedule, which allows investors to plan the timing of their cash
flow. The actual amount of the distributions may vary with fund
performance, interest rates, and general market conditions.
Still, a stable monthly cash flow is easier to create with CEFs
than with individual bonds, mortgages, and preferred stocks ---
and they are significantly less risky. Many funds make their Capital
Gains Distributions early in the year following the actual transactions.
This may cause some inconvenience for accountants, but think of
the potential for income increasing management strategies! (Remember,
it's your accountant's job to make you happy...not vice versa.)
Investment Risk: All true investments involve similar types of
risk. Closed End Funds involve the same risks as common stocks:
prices do fluctuate; management skills vary from company to company;
markets rise and fall; interest rates change. The rules of Investing
(Quality, Diversification, and Income) and of Management (Planning,
Organizing, Controlling, Decision Making) always apply.
CEFs are not miracle drugs, just another means to the end of creating
a more manageable, safer, and more productive portfolio. They are
the only income securities used in Market Cycle Investment Management
"Mirror Portfolios".
Steve Selengut
http://www.kiawahgolfinvestmentseminars.com/
http://www.sancoservices.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The
Book that Wall Street Does Not Want YOU to Read"
Published - August 2010
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