Closed-end funds might be somewhat of an enigma to the average investor, but since the launch of our Closed-end Fund Centre we have given then their fair share of attention on Morningstar.co.uk. CEFs have some interesting benefits--but also a few idiosyncrasies--so before you jump in, it's worth spending the time to get familiar with this oft-misunderstood investment vehicle.
To help shed some light, we've outlined some common mistakes that CEF investors should avoid. Also be sure to check out our recently updated CEF Solution Centre for an array of courses on closed-end funds, ranging from the very basic to more advanced topics for seasoned CEF investors.
Mistake No. 1: Buying the CEF With the Biggest Discount
Like open-end mutual funds, CEFs invest in a portfolio of securities, but unlike traditional mutual funds, after a CEF launches, it is closed to additional capital inflows and capital outflows. In other words, after a fund's "IPO," you can't send a check to the closed-end fund company to buy shares of a closed-end fund. The fund company also does not regularly redeem its shares. Instead, shares of the fund are bought and sold on an exchange, like an equity.
Because of this dynamic, CEFs have two values associated with them: one, the net asset value, which is the market value of the fund's underlying holdings; and two, the market price at which investors can buy and sell shares of the fund on the exchange. In almost every case, the fund's share price will be higher or lower than the NAV, leading to premiums and discounts being associated with the fund.
It may seem like common sense to purchase the CEF that is trading at the biggest discount to its NAV. But CEF discounts are not like discounts at retail stores. Looking solely at absolute discount figures can lead investors to paint an overly simplistic and optimistic picture. Consider that a CEF's NAV and share price can converge in more than one way. The shares could appreciate (which would be good for investors). But the value of the underlying portfolio (the NAV) could also depreciate (not so good). In either case, the discount will narrow, but the result for investors is decidedly different.
Furthermore, if the CEF typically trades at a large discount, it will tend to stay at a large discount, barring any corporate action from the fund's board of directors. The same can be said of premiums. Even in periods of extreme market volatility, CEFs that typically trade far below or far above the universe's average discount will more than likely continue to trade that way, even if during the downturn the premium turns to a discount.
This is not to disparage the role of absolute discounts entirely. For example, income-seeking investors can use absolute discounts to begin screening for funds that may offer enhanced income returns. (But your homework doesn't end with the distribution rate alone. More on that below.)
For better context, investors should consider a CEF's discount or premium relative to its historic averages. Moreover, investors should note that discounts and premiums aside, what really matters is the share price at the time of purchase and the subsequent total return of the CEF.
CEF strategist Mike Taggart went into more detail on the reasons why CEFs trade at a discount to their NAV and how investors should avoid value traps in our latest CEF webinar. And this article discusses how investors could use relative CEF discounts.
Mistake No. 2: Buying the CEF With the Biggest Distribution
Distribution rates are one of the primary drivers of CEF share prices; funds that post high distribution rates are guaranteed to attract investor interest. But investors should regard CEF distributions with a critical eye because the distribution figure you see may not necessarily be what you get.
First, it is important to establish that the term "CEF distribution" is not interchangeable with "yield" or "dividends." In other words, investors should be careful not to misinterpret a CEF's distribution as what its portfolio is actually generating in terms of income. This is because CEF distributions can have several potential sources: income from bond and/or equity holdings, realised capital gains, and return of capital.
Although distributions from net investment income are considered relatively sustainable, distributions from capital gains are less reliable because there is no certainty that the portfolio can continue to pump out those gains going forward. And importantly, investors must realise that CEF distributions may also comprise return of capital. There are, essentially, three types of return of capital. The most pernicious is what we at Morningstar call "destructive returns of capital"--meaning, investors are essentially getting their own investment dollars back (minus expenses). If the fund consistently dips into destructive return of capital to pay for distributions, it could eventually hack away at the fund's net asset value.
Mistake No. 3: Jumping Into a New CEF at Its IPO
Investors who may consider jumping on the opportunity to buy into a new CEF at its IPO should think twice. Most CEF IPOs are sold by brokers who almost certainly have a financial incentive for getting investors to buy in.
Plus, investors will always be purchasing CEF IPO shares at a premium. It's true that paying a premium doesn't eliminate the opportunity for you to make money over the long term, but it does mean that you overpaid for the assets in the fund without any guarantee of future fund performance.
Before buying into a CEF at its IPO, ask yourself: What makes this fund so unique that it has to be bought right now, at the IPO, for a premium? Typically, there is another, pre-existing CEF offering the same strategy and, if you're patient, you will almost certainly be able to purchase either fund later--at some point during the course of a full market cycle--at an absolute discount.
We recommend that investors wait until the fund establishes a good track record and its initial premium dissipates.
For more information on CEF IPOs, as well as other news from the CEF world, keep track of our weekly CEF Times feature, written by Morningstar Director of Closed-end Fund Research Jackie Beard.
Esther Pak is an assistant site editor of Morningstar.com, a sister site of Morningstar.co.uk
