Understand How Closed-End Funds Work Before Investing

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By Cameron Huddleston

In today's low-interest-rate environment, the high distribution rates offered by closed-end funds have become increasingly appealing to investors who are looking for decent yields. However, the Financial Industry Regulatory Authority, the brokerage industry's self-regulatory body, is warning investors that they need to understand these funds fully before investing in them.

"It's really a 411 rather than a 911," says Gerri Walsh, Finra's senior vice-president for investor education, about the recently issued investor alert on closed-end funds. Money invested in these funds has been on the rise, she says, and about two dozen new closed-end funds have been launched so far this year. With the growth in popularity of these funds, Finra has received questions and complaints about them. So the timing seemed right to issue an alert to help explain closed-end funds to investors, Walsh says.

In particular, Finra is alerting investors that they need to understand that a closed-end fund's distribution rate isn't the same as a yield. Like mutual funds, closed-end funds manage a portfolio of stocks, bonds or other securities. A mutual fund's yield reflects its interest and dividend income. However, distributions from a closed-end fund can also include a return of capital, which means the money comes from the fund's actual assets rather than income generated by those assets.

For example, say you invest in a closed-end fund with a 5 percent rate of distribution that's primarily a return of capital. In effect, you're getting some of your principal back, says Walsh, which is very different from making a 5 percent return on interest and dividend income alone. %VIRTUAL-article-sponsoredlinks%Plus, closed-end funds that return capital can carry a higher level of risk because the asset base needed to generate income to pay future distributions is being eroded, according to the Finra investor alert.

Keep in mind, too, that closed-end funds' share prices can vary from the per-share value of their underlying holdings because these funds initially offer a fixed number of shares that trade on an exchange. (Closed-end funds can issue more shares later through rights offerings.) As such, market demand dictates share-price fluctuations.

Closed-end funds tend to trade at a discount to the value of their underlying shares, but some trade at a premium. In contrast, the price of a traditional mutual fund is always determined by the value of its underlying assets. Finra cautions investors to find out from a closed-end fund's website (or the exchange where it is listed) how its price compares to its inherent value. Morningstar.com (MORN) provides information on funds' historical trading patterns.

In addition, check to see whether a closed-end fund relies on leverage -- making investments with borrowed money, essentially -- to enhance returns. Many closed-end funds do. The risky strategy can pay off when bets go the fund's way, but losses are magnified when investments go south. Some traditional mutual funds also use leverage. A closed-end fund's prospectus or annual report will outline if and how leverage will be used to meet the fund's investment objectives.

None of this means closed-ends funds can't be good investments. Kiplinger's Retirement Report recently recommended a few closed-end funds that invest in emerging-markets debt and municipal bonds because the funds were trading at attractive discounts. Just be sure you understand what you're buying before you buy it.

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Understand How Closed-End Funds Work Before Investing

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."
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