Understand How Closed-End Funds Work Before Investing

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 is not 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.

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For example, say you invest in a closed-end fund with a 5% 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% return on interest and dividend income alone. 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 Web site (or the exchange where it is listed) how its price compares to its inherent value. Morningstar.com 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 (see Snag Good Bargains in 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.