CEFs – What They Are and Why You Need to Understand

Investors are looking for better investments that offer protection from inflation and growth potential given the rocky investment environment we’re all dealing with. Are CEFs the answer? Maybe.

What are Closed End Funds (CEFs)?

CEFs are like mutual funds in that they pool investors’ assets. Managers take that money and buy shares or bonds of companies they think offer attractive potential returns.

But mutual funds can keep on taking in money. As new money comes in the door, the managers of mutual funds simply buy more investments. Closed End Funds (CEFs) are very different. Once they raise a set amount of money, that’s it. No more money is allowed in. This sets up a very different dynamic for CEF investors as compared to mutual fund investors.

If you own a mutual fund, the value of that fund will always be very close to the value of the investments held in that fund. Let’s use a simple example.

Say the ABC mutual fund raises $100 and issues 100 shares for $1 a piece. It buys 10 shares in the XYZ Company for $10 a piece. If the value of XYZ rises to $12 a share, the value of the fund rises to $120 and each share is worth $1.20. That’s what mutual fund performance is all about.

If the ABC fund now sells 100 additional shares, they’ll get a total of $120 from new investors (this is somewhat oversimplified, but it illustrates the point). The total assets of the mutual fund will be $240 and there will be 200 shares – or a value of $1.20 a share. So far so good.

Let’s assume that ABC is a Closed End Fund instead of a mutual fund. Let’s assume ABC sells 100 shares for $1 a piece. They sell all the shares and collect $100. The manager of ABC goes out and buys 10 shares of XZY Company for $10 a share. And just like before, the value of XYZ goes up to $12 a share. The value of the shares now becomes $1.20, just like the mutual fund.

But now, other people want a piece of the action. Since the CEF can’t issue more shares, new investors are going to have to fight with each other over the existing shares. What happens to the value of ABC Closed End Fund when lots of investors are hungry to buy shares? The price rises.

So even though the underlying value of ABC is $1.20, the price will be bid up if investors think the managers are particularly skilled. Because the price of the shares of the closed end fund exceeds the value of the underlying assets, these shares are known to be trading at a premium.

Of course the opposite can also happen. Assume people expect the manager to do a particularly poor job and nobody wants those assets or the manager. If existing share owners want out, they’ll have to settle on a price below the value of the underlying securities.

CEFs are usually actively managed and as such, the manager of the fund plays a key role. While most mutual funds are actively managed too, many ETFs aren’t. When people buy investments that are actively managed, it means they are trying to do better than the overall market or they want to limit downside risk when the market does poorly. They look to the manager to deliver these results. Passive investors are happy to accept market returns.

Another differentiator between CEFs and other mainstream investments is the use of leverage – or borrowed money. According to the Investor’s Business Daily, about three out of four Closed End Funds are leveraged. That means if the manager is right on what to buy, the returns will be greater than the overall market because the manager is using borrowed money to invest. But if the manager is wrong, the returns will be worse than the market. Possibly much worse.

The Investor’s Business Daily looked at the period 9-1-2008 through 12-31-2008. Granted this was a very tough year for the market, but it illustrates the point pretty well. During that period, the typical high-yield CEF lost 36.8% while the high-yield index “only” lost 19.9%. So the CEF lost almost twice as much, and that was mainly because of the leverage and borrowed money it invested.

The leverage will work for or against you if your fund buys junk bonds, preferred shares or blue chip stocks. It doesn’t matter. Of course, during good times, this leverage can really pay off for you. But in deciding between a CEF and a mutual fund, the main consideration should be your goals and how much risk you are comfortable with.

If you buy a great CEF during a very bad market, you might be able to buy it at a significant discount. On top of that, if the market starts behaving well, you might zoom ahead quicker than a mutual fund or ETF because of the leverage.

On the other hand, if the market does poorly, that discount might become greater and the use of leverage will amplify your losses.

As you can see, you have to be very clear on what your appetite for risk is before making this decision . This is yet another example where simply looking at returns and selecting your investments based on those returns could end up to be a very costly error.

Do you think a CEF would work for you? Is it a good investment or a poor one?