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Treasury inflation-protected secu-
rities, or TIPS), a mixture of stocks
and bonds (balanced funds), cov-
ered calls, preferred stocks, real
estate investment trusts (REITs)
and commodities. Just as is the
case for open-end mutual funds,
two key factors for choosing CEFs
are long-term historical perfor-
mance and the expense ratio
(annual fee as a % of assets).
Closed-end funds differ from standard open-end
mutual funds in three main ways:
» CEFs have a fixed number of shares, while the
number of shares in an open-end mutual fund [or
an exchange-traded fund (ETF)] changes depend-
ing on investor demand. Because closed-end funds
have a fixed asset base, they can more easily buy
illiquid investments (investments that are traded
less frequently or are difficult to quickly buy and
sell). CEFs can also more easily borrow money
against their asset base, with the borrowing leading
to financial leverage.
» Closed-end funds are traded on the open market.
Investors buy and sell CEFs throughout the day in
the same manner they buy and sell common stocks
and ETFs. This intraday trading differs from open-
end mutual funds, where investors buy from and sell
shares to (redeem from) the mutual fund company
using the end-of-day net asset value (NAV).
» Because CEF transactions occur between investors,
closed-end funds trade at a market price that is typi-
cally at a premium or discount to the NAV of the
fund. Also, low trading liquidity can be an issue with
some CEFs, making it difficult to buy or sell many
shares without unfavorably moving the price.
Buying a Closed-End Fund at a Discount
One of the traits that make closed-end funds attractive
is the ability to buy a dollar’s worth of net asset value for
less than a dollar. Such situations create the potential for
capital gains to be realized both from positive returns for
the CEF’s portfolio and a narrowing of the CEF’s discount
to its NAV.
The formula for calculating a CEF’s premium/discount
(P/D) is:
P/D = (Market Price ÷ NAV) – 1
For example, say a closed-end fund trades with a mar-
ket price of $11 and has a net asset value of $10. This fund
would trade at a 10% premium [($11 ÷ $10) 1 = 0.10]. A CEF
The Advantages and
Risks of Closed-End
For those seeking to earn higher yields than
available from mutual funds, closed-end
funds can be enticing due to their low-cost
leverage and higher dividend yields.
When investors speak of mutual funds, they almost
always refer to a specific class of mutual funds known
as open-end mutual funds. Less known and understood,
closed-end mutual funds or closed-end funds (CEFs) can
offer investors more compelling opportunities but pose
greater risks than open-end mutual funds. Closed-end
funds provide investors the ability to buy discounted
assets on the cheap” and amplify investment income
through low-cost leverage. However, CEF discounts and
leverage serve as a double-edged sword that can cut in-
vestors particularly deep in bear markets.
This article covers the basics of closed-end funds,
including the following:
» How closed-end funds work and why investors buy
» Key risks of closed-end funds,
» Where to find information on closed-end funds and
» Timing of closed-end funds—when are the most
opportune times to buy?
Closed-End Funds vs. Mutual Funds
Closed-end funds, like open-end mutual funds, invest
in assets on behalf of their shareholders. Asset classes
include stocks (U.S., international and sector funds), bonds
(municipal, convertible, high-yield, international and
Matthew Crouse, CFA, MBA, Ph.D.,is a
visiting assistant nance professor at West-
minster College in Salt Lake City, Utah. Find
out more at www.aaii.com/authors/matthew-
Just as is the case
for open-end mutual
funds, two key factors
for choosing CEFs are
long-term historical
performance and the
expense ratio (annual
fee as a % of assets).
© 2021 by the American Association of Individual Investors, 625 N. Michigan Ave., Chicago, IL 60611; (312) 676-4300.
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Use of Leverage to Boost Income
One key CEF feature, particularly of bond closed-end
funds, is leverage. Bond CEFs borrow money at lower
short-term rates (rates lower than what individuals borrow
at) and invest this money at higher long-term rates to earn
additional income. Leverage thus allows closed-end funds
to pay higher interest/dividends than standard open-end
mutual funds.
CEFs typically achieve leverage by borrowing money
through issuing debt or preferred shares. The amount of
debt or preferred shares a closed-end fund can borrow
is limited by the Investment Act of 1940 to a maximum
of one-half (for preferred stocks) or one-third (for debt)
of total managed assets. Translating asset ratios to NAV
ratios means that a closed-end fund can borrow up to $1.00
for every $1.00 of NAV if using preferred stocks and up to
$0.50 for every $1.00 of NAV if using debt.
Not all closed-end funds use leverage but most bond
CEFs do.
Discounts and Leverage Risk in Downturns
With market sentiment a key driver of CEF discounts, it
should be no surprise that closed-end funds trade at larger
trading with a market price of $9 and NAV of $10 trades at a
10% discount [($9/$10) 1 = 0.10].
I like to look for closed-end funds trading at discounts,
particularly income funds, as it means that I have more
assets working for me than what I paid for the CEF. Whether
a closed-end fund trades at a premium or discount is based
on supply and demand for that CEF. I’ve found supply and
demand to be influenced by the following factors:
» Overall market sentiment and popularity of the asset
class in which the CEF is invested;
» Historical price and NAV performance;
» Leverage and risk (important in market downturns);
» Seasonality, including tax-loss selling;
» The reputation of the CEF manager, including both
investment ability and efforts to keep the discount
» CEF expense ratio (extremely expensive funds tend
to trade at large discounts);
» Dividend yield (higher-yield funds tend to trade at
smaller discounts); and
» Liquidity (certain funds with low trading volumes
can trade at large discounts).
Historically, the majority of CEFs have traded at dis-
counts, although premium CEFs are not uncommon.
Closed-End Fund Discounts Widen During Bear Markets
The two charts show the median discount of U.S.-based closed-end funds during the 2008–2009 global financial crisis and the 2020
coronavirus pandemic panic. During bear markets, CEF discounts tend to widen, amplifying investor risk as closed-end fund market
prices drop more than the fund’s underlying net asset value.
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09
Median Discount of U.S. CEFs During Financial Crisis
CEFs traded at deep
discounts during the
heart of the global
financial crisis.
Jan-20 Mar-20 May-20 Jul-20 Sep-20 Nov-20
Median Discount of U.S. CEFs During the Pandemic
CEFs experienced a sharp drop
followed by a rebound to roughly
a –10% level, down from the –5%
level prior to the pandemic.
Source: Almitas Capital.
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discounts during market sell-offs. For example, a closed-
end fund that normally trades at a 5% discount may trade
at a 15% discount in a bear market sell-off. See Figure 1 for
examples of discount behavior during market panics.
Discounts enable investors to acquire more shares of
a closed-end fund for a given amount of available dollars.
They hurt existing shareholders of the CEF by reducing the
quoted value of their holding. Should a CEF shareholder
need to sell the fund during a downturn, they run the risk
of selling at a bigger discount to NAV than they purchased
the CEF at.
Just like discount risk, lever-
age risk tends to amplify price
volatility and underperformance
in market sell-offs. For example,
if an unleveraged fund loses $1.00
in NAV, a leveraged fund borrow-
ing $0.50 on the $1.00 would lose
$1.50. In severe bear markets,
some CEFs have lost enough assets to be forced to sell
investments and reduce leverage in order to maintain the
Investment Act of 1940 asset coverage ratios.
Net-net, a leveraged CEF investor tends to experience
the bear market declines amplified by discount widening
and leverage. The heightened risk can make buy-and-hold
investing in CEFs more challenging. For this reason, I and
many other investors take a more active approach to CEF
investing—buying closed-end funds when discounts are
wide and selling them when discounts are narrow.
Even buy-and-hold CEF investors should
understand the risks of leveraged closed-end
funds to avoid buying the most aggressively
leveraged funds and then feeling forced to sell
these CEFs at bear-market lows to preserve
their investor capital.
Where to Find CEF Information
I think the best overall data source on
closed-end funds is CEF Connect (www.
cefconnect.com). This free site (with registra-
tion required for some features) is operated by
Nuveen and has several useful tools:
» A Fund Screener that lets you screen by
asset class as well as sort and set param-
eters on items like expense ratio, dis-
count, leverage, performance, dividend
yield and a host of other factors.
» A Quick Search lookup that pulls up
information on a specific fund, given
the fund name or ticker. The site pro-
vides tabs for Overview, Fund Basics,
Pricing Information (including historical discounts),
Performance and Portfolio Characteristics.
Once you have found a closed-end fund to consider buy-
ing, I recommend you get informational material directly
from the CEF’s website. CEF Connect has a link to the fund
company website on its Fund Basics page, but you can
also use Google to find it. Once on the company website, I
look for all fund materials, including the annual and semi-
annual reports, where I try to learn about strategy, portfo-
lio holdings, expenses and performance. CEF Connect is
not always 100% up to date for all CEFs, so I go to the fund
company website to get information straight from the
horses mouth.
I also look for net income information for bond and
other fixed-income CEFs. Bond CEFs report net investment
income per share, which I compare with dividend per
share. Bond CEFs also report undistributed net investment
income (UNII), which is the accumulation of income that
has not yet been paid out. If UNII is negative, more income
has been paid out than earned.
All else equal, bond CEFs with net investment income
greater than the dividend and positive UNII are better to
own than those with net investment income less than the
dividend and negative UNII. CEFs with the former (greater
NII and positive UNII) may raise dividends, while CEFs
with the latter (less NII and negative UNII) may reduce
That said, these measures are not 100% accurate for
predicting dividends. For example, some CEFs pay fixed
CEF Connect Closed-End Fund Screener
Among the useful features on the CEF Connect website (www.cef
connect.com) is its closed-end fund screener. This free tool allows
investors to search for funds based on a variety of characteristics,
including the magnitude of their discount to net asset value.
Source: CEFConnect.com.
Just like discount risk,
leverage risk tends to
amplify price volatility
and underperformance
in market sell-offs.
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managed distributions that are greater than the actual
amount of income earned. With such distributions, the
hefty dividend yield may be deceiving, as investors could
be partially getting their money back in what is deemed a
return of capital. [Editor’s note: A return of capital distri-
bution can add a layer of complexity to taxes, as it reduces
the cost basis of the shares owned.]
One note on expenses: I deduct leverage expense from
the expense ratio because the leverage expense generates
an even greater amount of income. However, even with
that adjustment, CEFs tend to have higher expense ratios
than open-end mutual funds.
Opportune Times to Buy
As shown in Figure 1, CEF discounts tend to widen
during market panics. As such, market panics can be an
opportune time to buy CEFs. However, investors must still
be aware of leverage and sector risk. For example, several
leveraged CEFs that invested in energy master limited
partnerships (MLPs) lost most of their value during the
coronavirus pandemic sell-off and were forced to both
reduce leverage and sell portfolio holdings near the bot-
tom of the market.
From a seasonality perspective, the
fourth quarter has historically been the
best time of year to buy closed-end funds,
as shown in Figure 2. Like the January effect
for small-cap stocks, CEFs tend to sell off at
the end of the year and rebound during the
new year. This has led to attractive buying
opportunities in October through Decem-
ber. This seasonal effect tends to be more
pronounced in closed-end funds that have
declined during the current calendar year
as investors sell them for tax losses, lead-
ing to depressed prices and larger year-end
For those seeking to earn higher yields
than available from open-end mutual funds,
closed-end funds can be enticing due to
their low-cost leverage and higher dividend
That said, neither CEFs nor the assets
they invest in are cheap as I write this. As
of June 28, 2021, U.S.-based CEFs traded at
a 2.6% median discount, which is narrow
relative to the historical averages. Bonds
themselves are expensive, with the 10-year
U.S. Treasury yielding less than 1.5% and
credit spreads at low levels. Additionally, stock market
indexes such as the S&P 500 index are trading at high
price-earnings (P/E) ratios.
Thus, the current risk-reward trade-off of CEFs is less
promising than usual. As previously stated, closed-end
funds offer the most upside when they trade at wider-
than-normal discounts to NAV and when the assets they
own have high appreciation potential.
Acknowledgments: I would like to thank Almitas Capital
for providing access to historical closed-end fund data.
Hear Professor Crouse discuss closed-end funds in our
August 18 Individual Investor Show.
Closed-End Bond Funds Versus Individual Bonds: A
Case Study by Hildy Richelson and Stan Richelson, April
Using Seasonal and Cyclical Stock Market Patterns by
Jeffrey Hirsch, June 2013
Researching Closed-End Funds by CI Staff, April 2014
Seasonality of Closed-End Fund Discounts
Closed-end fund discounts tend to widen during the fourth quarter and tighten
during the first quarter. The widening of discounts tends to be the most
dramatic in those CEFs that have dropped during the year and are incurring the
highest level of apparent tax-loss selling.
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Median Discount to NAV During Different Times of Year (1996–2020)
The first quarter tends to be a
good me to sell CEFs.
The fourth quarter tends to be
a good me to buy CEFs.
Source: Almitas Capital.