A A I I J o u r n A l AU G U S T 2 0 2 1 2 5

A A I I . C O M / J O U R N A L

P O R T F O L I O S T R AT E G I E S

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

Funds

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.

BY MATTHEW CROUSE, CFA, MBA, PH.D.

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

them,

» 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-

crouse.

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).

A A I I . C O M / J O U R N A L

2 6 A A I I J o u r n A l AU G U S T 2 0 2 1

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

small;

» 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.

FIGURE 1

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.

–30%

–25%

–20%

–15%

–10%

–

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09

Discount

Median Discount of U.S. CEFs During Financial Crisis

CEFs traded at deep

discounts during the

heart of the global

ﬁnancial crisis.

–25%

–20%

–15%

–10%

–5%

Jan-20 Mar-20 May-20 Jul-20 Sep-20 Nov-20

Discount

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.

A A I I J o u r n A l AU G U S T 2 0 2 1 2 7

A A I I . C O M / J O U R N A L

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

horse’s 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

dividends.

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.

A A I I . C O M / J O U R N A L

2 8 A A I I J o u r n A l AU G U S T 2 0 2 1

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

discounts.

Conclusion

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

yields.

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. ▪

MORE AT AAII.COM/WEBINARS

Hear Professor Crouse discuss closed-end funds in our

August 18 Individual Investor Show.

MORE AT AAII.COM/JOURNAL

Closed-End Bond Funds Versus Individual Bonds: A

Case Study by Hildy Richelson and Stan Richelson, April

2017

Using Seasonal and Cyclical Stock Market Patterns by

Jeffrey Hirsch, June 2013

Researching Closed-End Funds by CI Staff, April 2014

FIGURE 2

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.

–8.0%

–7.5%

–7.0%

–6.5%

–6.0%

–5.5%

–5.0%

–4.5%

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.