By John Wasik
CHICAGO, April 26 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
Leading the pack is the Pimco Dynamic Credit Income Fund
(PCI), which raised $3 billion for the world's largest bond-fund
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
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
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
But for the last 12 months, the DoubleLine fund has gained
almost 11 percent on price and more than 13 percent on net asset
value. That's compared to the Vanguard fund's gain of less than
2 percent for both price and net asset value. Keep in mind,
though, that past returns are no guarantee of future gains.
When you compare expenses, 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.