Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

A Beginner's Guide to Closed-End Income Funds

The key to boosting income lies in a security most investors might not be familiar with.
 
Nevertheless, more than 1,250 of these securities trade on U.S. exchanges. They invest in every almost every possible sector and niche of the market (from stocks and bonds to REITs, MLPs, municipal bonds, preferred stocks, and more). But what they're best known for is income.
 
These securities are called closed-end funds.
 
Closed-end funds are publicly traded investment companies that raise capital through an initial public offering and then use the proceeds to invest in securities.
 
Similar to common stocks, closed-end funds usually trade on one of the major U.S. exchanges. However, unlike regular stocks, they represent an interest in a portfolio managed by investment advisors. These managers typically concentrate on a specific industry, country or sector.
 
Unlike traditional open-ended mutual funds, closed-end funds don't have cash going in and out of the fund -- only a set number of shares trade. If you want to buy in, you purchase your shares from another investor, just like a stock.
 

The structure lends itself to paying out high income because they don't have to keep money available for redemptions and can invest all its assets.
 
It shouldn't be a surprise that closed-end funds that pay income are easy to come by. A quick screen shows 487 CEFs currently yielding more than 7% --  187 yield 10% or higher. Even better, most closed-end funds pay distributions on a monthly basis -- 897 of the 1,275 to be exact.
 
Adding one of these high-yielding gems to your portfolio should give your monthly income a quick boost. However, the last thing any investor should do is buy into a fund simply because it pays an enticing yield.
 
Just like any other investment, you need to do your homework. But since funds are different than a normal stock, there are three unique metrics you should keep an eye on:
 
Past Performance is a Good Guide

Past performance is a fund's resume. While nothing is certain, you can generally increase your chances of choosing a solid-performing fund by selecting one that has proven itself already. In particular, you want to ask:
 
  How has the fund performed in good markets and bad?
  How has the fund performed relative to its sector?
  Does the fund perform well in the long term and/or the short term?
 
 If you're most worried about safety, a good place to start your search is with funds that were able to hold up in the last downturn. These may not offer sky-high gains in a rising market, but they've proven their mettle in one of the worst downturns in recent memory.
 
Discounts and Premiums
Sometimes closed-end funds trade out of line with their net asset value, meaning the share price may be higher or lower than the per-share value of the assets held by the fund.
 
Some funds may trade out of line with their net asset value for years. Therefore, it's important to look at the discount or premium in relation to its historical average. The key is to find funds trading for less than their average historical discount or premium.
 
Avoid Return of Capital Distributions

Before buying into any fund, you'll want to know where the dividend payments are coming from. You can usually find this by look at the last year's tax breakdown on the fund's website.
 
Many funds have "managed distribution policies." This is a fancy way of saying they plan to make the same payment each month, no matter how much income the fund earns from investments.
 
Usually the fund sets payments at a sustainable level. But in some cases, a fund may earn less income than it pays out -- forcing it to dip into its assets to maintain the payment.
 
These distributions are classified as return of capital. Such payments are simply a return of your principal and erode the value of the fund. In short, it's usually best to avoid funds making return of capital payments.