One of the first things you learn in economics is that there's no such thing as a "free lunch." And if you're thinking of investing in a closed-end fund, you need to keep that in mind...
There's No 'Free Lunch' in Closed-End Funds
By Joe Austin, senior analyst, Chaikin Analytics
One of the first things you learn in economics is that there's no such thing as a "free lunch."
And if you're thinking of investing in a closed-end fund, you need to keep that in mind...
Put simply, these are a type of mutual fund. They issue a set amount of shares through an initial public offering ("IPO") to raise money for their investments. After the IPO, their shares trade on a stock exchange. But closed-end funds don't create new shares.
Due to their distributions, these funds are popular with investors. Distributions from a closed-end fund are like a dividend from a stock.
But there's one big difference...
In most cases, companies pay dividends out of retained earnings. That means money they already earned.
But closed-end funds don't have to do that. And some of them use the wiggle room to keep distributions high.
They pay out more than they earn. And sometimes they even borrow money to make up the difference.
That might attract more investors... but it doesn't make the fund a good investment.
And that can be a problem.
Now, there are plenty of closed-end funds that don't engage in financial engineering. But some do. And as an investor, you need to look before putting money to work in them...
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Keep in mind that closed-end funds have been around since the 1800s. The first ones functioned more or less like investment clubs.
They followed simple strategies – like buying stocks, bonds, or even blends of both.
And after the fund made some money, the manager would return it to shareholders via a distribution.
Closed-end funds also have high fees. That means they're an attractive business for the companies that manage them.
A recent study by Forbes showed that the management fees for closed-end funds start out anywhere from double to triple those of an exchange-traded fund ("ETF").
So to be competitive and attract capital, managers invent all sorts of strategies to keep distributions high.
Some use fancy option strategies to generate income. Others venture into risky investments like high-yield bonds, private equity, and hedge funds.
But the easiest (and most popular) way to boost returns is by borrowing money – also known as leverage.
And leverage works like a double bonus for the manager. First, along with the money you have in the fund, the manager also earns fees on the borrowed money. And second, fund investors have to pay the interest expense.
That same Forbes study found that after accounting for borrowing costs, the fees on some leveraged closed-end funds come in as high as 7%.
That's plenty of incentive for bad behavior.
To get a handle on the closed-end-fund opportunity, I took a look at the largest closed-end funds with market caps greater than $1 billion. That's about 60 funds.
The funds include most any strategy you could want – equites, bonds, blends, and everything in between. One fund even buys physical gold and silver.
And while the average yield was an impressive 8.4%, very few funds outperformed a relevant benchmark – like the S&P 500 Index or the Bloomberg U.S. Aggregate Bond Index.
In fact, most of the equity funds lagged the market on a year-to-date and three-year basis.
Another popular reason for investing in closed-end funds is that investors can sometimes buy them at a discount. That's like getting a dollar for 90 cents.
But there's not much of a free lunch there, either. Using book value as a proxy for the fund's net asset value ("NAV"), most funds were valued right around their NAV.
Now, the Power Gauge doesn't publish a rating on most closed-end funds. That's because we can't get enough transparency on the underlying holdings. Or if we can, the fund might hold lots of securities outside of U.S. equities.
But the Power Gauge does publish ratings on hundreds of ETFs. And plenty of them are rated "very bullish" or "bullish." That's a far less complicated starting point for investing in funds.
The bottom line is that if you're tempted to put money to work in closed-end funds, pay close attention to leverage. And watch how they make those distributions.
Remember... there's no free lunch.
Good investing,
Joe Austin Editor's note: Right now, Chaikin Analytics founder Marc Chaikin is using the Power Gauge for a breakthrough new strategy for 2024 and 2025...
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Market View
Major Indexes and Notable Sectors
# Hld: Bullish Neutral Bearish
Dow 30
-0.96%
7
19
4
S&P 500
-1.98%
109
304
80
Nasdaq
-2.52%
17
73
10
Small Caps
-1.66%
467
1049
400
Bonds
+0.13%
Utilities
+1.04%
15
15
0
— According to the Chaikin Power Bar, Small Cap stocks and Large Cap stocks remain somewhat Bullish. Major indexes remain all bullish.
* * * *
Sector Tracker
Sector movement over the last 5 days
Communication
+1.57%
Materials
-1.28%
Energy
-1.36%
Financial
-1.36%
Industrials
-1.45%
Discretionary
-1.64%
Health Care
-1.7%
Staples
-1.97%
Utilities
-2.06%
Real Estate
-2.75%
Information Technology
-2.99%
* * * *
Industry Focus
Biotech Services
41
79
18
Over the past 6 months, the Biotech subsector (XBI) has outperformed the S&P 500 by +1.39%. Its Power Bar ratio, which measures future potential, is Strong, with more Bullish than Bearish stocks. It is currently ranked #7 of 21 subsectors and has moved up 5 slots over the past week.
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This work is based on SEC filings, current events, interviews, corporate press releases, and what we've learned as financial journalists. It may contain errors, and you shouldn't make any investment decision based solely on what you read here. It's your money and your responsibility.
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