Many investors out there are familiar with mutual funds. After all, the way most of us invest is via a 401k where company-appointed administrators offer a limited menu of choices for us — typically several mutual funds of varying flavor based on asset focus.
And since the rise of exchange-traded funds or ETFs, many investors have become accustomed to seeing these vehicles in the news along with the big mutual funds. After all, there is more than $100 billion in the SPDR S&P 500 ETF (NYSE:SPY) alone and nearly $70 billion in the flagship SPDR Gold Trust (NYSE:GLD).
But many investors might not be familiar with another kind of fund at their disposal — closed-end funds.
A closed-end fund is a publicly traded investment company that invests in securities according to its investment objective. Such funds are referred to as “closed-end” because, once the initial capital is raised, there are typically no more shares available from the fund sponsor.
This structure differs from open-end mutual funds, which continually issue and redeem shares and are priced once a day at NAV. The structure also differs from ETFs, which are priced continually throughout the day but fundamentally must reflect the constituent companies and assets on which they are based.
Here are some features of closed-end funds:
- Fixed Capital: This is a plus in the eyes of some. Because closed-end funds raise their capital and then close the door, they have a fixed amount under management. That means no constant pounding of the pavement to manage inflows and outflows associated with open-end funds, and less distraction for management.
- Supercharged Dividends If Your Timing Is Right: Like other funds, there is an underlying net asset value that should always be watched to determine the value of closed-end funds. But because they trade on exchanges subject to market pressures, sometimes closed-end funds trade at discounts to their net asset value. That means you can juice your yield because the dividends are based on the underlying portfolio, not the market pricing. As a practical example, suppose you own a stock that yields a $1 dividend and trades for $40 a share. That’s a 2.5% yield. But what if a closed-end fund owned that stock and was trading at a 10% discount to its NAV? Then you would own that same stock for $36 a share (pricing in that 10% discount) for a yield of 2.8%.
- NAV as ‘Overbought’ Indicator: Of course, the net asset value also can squeeze you on the other side of the dividend equation by overcharging you per share. But more importantly, any closed-end fund that is trading for significantly higher than its net asset value is like a stock with a nosebleed price-to-earnings ratio. Warning bells should go off, and unless you believe that some red-hot run is in order to bring actual assets above the valuation, you will want to steer clear or risk a correction in shares.
- Leveraged Returns: Many closed-end funds leverage returns with borrowed money — a risky process, but something that can result in big returns. Some closed-end funds borrow short-term at just 1% to 2% interest rates, then buy higher-yielding long-term investments to increase profits. Just beware: This cuts both ways — when interest rates start to climb, leveraged funds can lose money quickly.
There clearly are quirks to closed-end funds, but when used right they can help investors produce big returns and nice dividend yields.
3 High Yield Closed-End Funds That Focus on Stocks
Here are a few closed-end funds that focus on equities that are worth noting. These funds typically do not use leverage, since the rate spread from borrowing short-term and getting a yield long-term is mostly applicable to bond investing:
The Eaton Vance Tax-Managed Buy-Write Income (NYSE:ETB) is a fund that uses options to increase income so you don’t have to. ETB focuses on common stocks using a “covered call” strategy. The fund doesn’t use leverage. This Eaton Vance closed-end fund currently holds big, well-known names like Exxon Mobil (NYSE:XOM), Microsoft (NASDASQ:MSFT) and Apple (NASDAQ:AAPL). It’s a four-star fund as rated by Morningstar, and trades at a nearly 7% discount to its NAV right now. It also boasts a roughly 9% yield based on monthly distributions of 32.4 cents.
Another interesting closed-end fund to consider is the BlackRock Resources & Commodities Fund (NYSE:BCX). This fund also operates without leverage, but does use derivatives or commodity trading on top of its equity allocations. Although this closed-end fund has lagged the market considerably year-to-date with just 5% returns, it is trading at a 6% discount to NAV. It also boasts a 10% yield based on quarterly distributions of 35 cents — but could deliver even bigger dividends considering the payday of 66 cents last December. Underlying assets include fertilizer company Potash (NYSE:POT), metals giant Silver Wheaton (NYSE:SLW) and agricultural stock Monsanto (NYSE:MON).
The Dow 30 Enhanced Premium & Income Fund (NYSE:DPO) is operated by Nuveen Investments and trades for a 5% discount to its NAV right now. Like the others, it does not use leverage to achieve its returns — but still boasts a 7.9% yield based on 21.8 cents a quarter in distributions. Top holdings include, unsurprisingly, Dow stocks IBM (NYSE:IBM), Chevron (NYSE:CVX) and This “enhanced” Dow fund also dabbles in other megacaps, however, as well as swap contracts to amplify returns. The fund is rated four stars by Morningstar. DPO is up 9% year-to-date, which has outperformed the Dow.
2 High-Yield Closed-End Funds That Focus on Bonds
If you want to play high-yield bonds in the closed-end fund arena, here are two options for you. These funds do use leverage to juice returns:
Trading at an 8% discount to its current net asset value is Helios Strategic Income Fund (NYSE:HSA). The fund is up 14% year-to-date in 2012, and offers an impressive 6.7% yield based on monthly distributions of 3.5 cents and a rock-bottom share price just north of $6 at current writing — and it was leveraged about 28%. Top holdings include a 7.75% corporate bond for Anheuser-Busch InBev (NYSE:BUD) and a 5.7% bond for Dow Chemical (NYSE:DOW).
Be warned, however, that HSA can dabble in “below-investment-grade debt securities” — also known as junk bonds — as well as mortgage-backed securities, foreign government obligations and companies in bankruptcy reorganization proceedings or other debt restructuring. These can be risky propositions.
The NexPoint Credit Strategies Fund (NYSE:HCF) is another bond fund that uses leverage, to the tune of around 27% right now. It focuses on floating and fixed-rate loans and distressed/bankrupt corporate obligations to generate a 6.4% yield based on monthly payouts of 3.5 cents a share. As with Helios Strategic Income, these underlying debt instruments can be risky — but the yield is impressive. Shares of HCF are up just under 7% year-to-date, and holdings include loans to Genesys Ventures and Comcorp Broadcasting.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.