COLUMN-Closed-end funds provide yield, but at a price

Fri Apr 26, 2013 3:15pm EDT

By John Wasik

CHICAGO, April 26 (Reuters) - Investors chasing yield in this low-rate environment are jumping into alternative vehicles. That's helping closed-end income funds stage a comeback.

Such funds, which offer a fixed number of shares and are closed to new capital once they start operating, have their attractions, but investors should exercise caution. Expenses for closed-end funds tend to be higher than with exchange-traded funds, they are more complex and they usually carry more risk. Their active managers are free to use leverage and invest in a variety of assets in the hope of delivering higher returns than mutual funds with static bond mixes.

In 2008, initial public offerings of closed-end mutual funds fell off sharply, to just one, from about 30 the year before. They fell out of favor because of the market meltdown and other debacles. There were 11 in 2009, 12 in 2010, four in 2011 and 13 last year, according to Lipper, a Thomson Reuters company.

This year so far, there have been eight closed-fund IPOs - six in the first quarter alone, all of them income-oriented - raising some $5 billion. There are more on the way, according to Investment News.

Leading the pack is the Pimco Dynamic Credit Income Fund (PCI), which raised $3 billion for the world's largest bond-fund manager.

While it's too soon to tell whether the fund will live up to its high management pedigree, the fund may be worth watching to see whether it can outperform similar funds, including mutual funds or ETFs within the Pimco family.

PITFALLS TO CONSIDER

Investors buy and sell shares in closed-end funds like individual stocks, but I don't recommend trading them through full-service brokers. Each transaction earns the broker a commission that eats away at your return. If your broker is trying to sell you on a strategy of actively trading closed-end funds, be wary.

In the past, broker "churning" of closed-end funds has been a problem. In 2009, Merrill Lynch and UBS Financial Services were fined $150,000 and $100,000, respectively, by the Financial Industry Regulatory Authority (Finra) for recommending that customers sell their funds at a loss and use the proceeds to buy shares of new funds - a practice that could be considered churning because it generates extra commissions. Since those funds had sales charges of 4.5 percent, the turnover was lucrative for the brokers, which neither admitted nor denied the charges.

David Blain, a financial planner in New Bern, North Carolina, prefers ETFs for his clients over closed-end funds for a number of other reasons. ETFs are also traded on the stock market as if they were stock, but they carry lower management expenses and greater transparency. He doesn't like closed-end funds because the pricing structure "adds another layer of complexity and it's difficult for active management to add value."

To know whether you're getting a good deal, you have to understand the layers of closed-end fund pricing. Shares may trade at a premium or discount to the underlying holdings, expressed by what is called the net asset value. While premiums are always desirable, discounts are typically seen after an IPO period ends and underwriters withdraw their support. So the total value of the fund is a matter of market supply and demand and how much the fund's holdings are worth.

ETFs, on the other hand, offer lower internal costs, greater visibility of what managers own and tax efficiency, says Blain, who notes that many basic bond ETFs are commission-free through companies like Fidelity, Schwab and Vanguard. In addition, fund management expense ratios average 1.5 percent for closed-end funds, versus 0.31 percent for corporate-index ETFs.

HOW THEY STACK UP

It's difficult to compare the recent crop of closed-end funds to an index or single exchange-traded fund because several actively managed objectives are represented.

As an investor, you need to ask: How do they compare when you consider costs, risk and the impact of leverage? How much can you lose if interest rates decline 1 percent?

To figure out what's best for you, compare closed-end funds you're considering with ETFs or mutual funds with similar objectives. Many closed-end funds may be able to garner higher yield due to leverage - adding an additional layer of risk - although they may not pay off over time if their managers can't navigate interest-rate swings.

For instance, you could compare a relatively popular closed-end fund like the DoubleLine Opportunistic Credit Fund with the Vanguard Mortgage-Backed Securities Index Fund , since both hold mortgage-backed securities.

The DoubleLine fund, which was launched last year, is up 3.67 percent this year (through April 25) on net asset value and down 0.06 percent on price, compared with a 0.36 percent net asset value increase and a 0.38 percent price gain for the Vanguard fund.

When you compare expenses, though, it's no contest: DoubleLine will charge 1.3 percent annually in addition to a brokerage commission to buy shares, while Vanguard levies a 0.12 percent annual expense and you can buy it directly without a commission.