Closed-end funds (CEFs) are a popular way to generate high-yielding diversified portfolios for income-focused investors. CEFs are a type of mutual fund. They typically hold and manage a widely diversified portfolio of investments in their portfolios and then sell shares in that portfolio to investors on the open market.

However, the key distinction of a closed-end fund is implied in its name: once it issues stock on the open market in a one-time initial public offering (IPO), it is then closed for investment. Then, every time an investor buys a share of the CEF, a corresponding share is sold by another investor in the fund. In contrast, many other mutual funds and exchange-traded funds (ETFs) simply create a new share every time an investor purchases one on the open market. Likewise, they eliminate a share every time an investor sells a share on the open market.

The practical impact of this is that CEF share prices are determined by supply and demand on the open market. This sometimes results in wide disparities between the price of the CEF and the net asset value of its holdings. In contrast, most other mutual funds and ETFs generally trade in line with the net asset value of their underlying holdings.

In the rest of this article, we will discuss the pros and cons of investing in CEFs. Then, we will share a few CEFs that look attractive at the moment.

Advantages of Closed-ended Funds

One of the allures of investing in CEFs — as opposed to many ETFs — is that they provide professional “active” management. As a result — assuming the fund’s strategy and skill are good — they can potentially outperform over the long run. Furthermore, this active management sometimes can give investors access to strategies and even investments that they would not otherwise have. For example, many CEFs issue relatively low-cost leverage to juice the yield and total return potential of their fund. Very few — if any — ETFs employ a similar strategy. Other examples include CEFs that employ selling calls and puts to enhance the cash flow of their fund as well as some that target shares in privately held investments instead of purely targeting publicly traded securities.

Another big potential advantage of investing in CEFs is that they combine similar diversification to what is commonly found in ETFs and mutual funds with a stock price that is sometimes trading at a substantial discount to its net asset value. Meanwhile, at other times, the same CEF may appreciate to trade at a premium to its net asset value. This affords savvy investors three potential advantages:

1. They can get more stock for their money when buying at a discount to the net asset value.
2. It can also mean that their yield on cost is higher than it would have been otherwise had they purchased at net asset value.
3. If/when the CEF share price appreciates relative to its underlying net asset value, it further enhances the total returns generated by the portfolio.

As a result, these CEFs can theoretically achieve superior risk-reward to ETFs and mutual funds.

A third big advantage of CEFs is that CEFs often boast very attractive distribution yields. This is due to a combination of the dividends provided by their underlying holdings, the leverage they employ, options they may decide to sell and any potential discount to net asset value in the stock price.

Disadvantages of Closed-ended Funds

While most CEFs often offer eye-catching distribution yields and discounts to net asset value, they still come with some drawbacks.

First and foremost, CEFs generally charge much higher fees than ETFs. This is primarily because ETFs generally are managed passively by algorithms. CEFs, on the other hand, are generally actively managed by paid professionals. These professionals conduct research and employ strategies guided by a human portfolio manager who can adapt to evolving market conditions. While a 50-100 basis-point difference in annualized expense ratios may not seem significant, over time it can add up. Further, it can lead to significant underperformance for CEFs if their active management fails to make up the difference.

CEFs’ hefty management fees look even worse when considering that many of them end up closet-indexing. You may be fine with paying higher fees to gain access to a CEF that holds high-conviction positions and generates significant alpha over the long term. However, the vast majority of CEFs do not take this approach. While they charge investors for their active management services, they end up constructing a highly diversified portfolio that ends up being very similar to low-cost index fund portfolios in terms of performance and sector exposure. Yes, they might weight certain sectors and companies slightly higher relative to the indexes. But, with such broad diversification, they are virtually guaranteed to not outperform by enough to offset their hefty management fees.

In an attempt to offset the drag on returns posed by the hefty management fees and excessive diversification, many CEFs taking on considerable leverage. Sure, this can make the dividend yield and total return performance look good during bull markets. But once the market turns, it also leads to outsized losses and oftentimes a brutal dividend cut. In fact, in fierce market crashes, it can lead to margin calls and massive permanent capital destruction. This is because the fund may have to sell some of its underlying holdings at the worst possible time. There have even been cases as recently as the Covid-19 crash in 2020 in which CEFs have had to liquidate because they suffered such catastrophic losses from plunging equity prices.

Two funds that are worth considering at the moment in light of these guidelines are BlackRock Utilities Infrastructure & Power (NYSE:BUI) and Dividend and Income Fund (OTCMKTS:DNIF). BUI is more suited to conservative investors, and DNIF is more suited to aggressive investors. Both have little leverage risk, strong performance track records, reasonable management fees, and trade at attractive prices relative to NAV. Furthermore, they offer attractive and pretty sustainable dividends.

Investor Takeaway

Given the unique pros of CEFs, it’s clear they can be a useful part of an income investor’s portfolio. However, investors who buy CEFs need to be careful to avoid the pitfalls that come with taking on overleveraged funds, funds with expense ratios that are too high relative to their total return track record, and funds that trade at premiums to the net asset value.

On the date of publication, Bob Ciura did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.