Trading Closed End Funds’s (CEF), Why And How?

avatar By: IS
Date posted: 07.15.2013 (3:00 am) | Write a Comment  (0 Comments)

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cef-wsjToday, since I did not have a new tech stock pick to open, I decided to do something that I should do more frequently:) Go into the mail bag:) I get most questions through email (from mailing list members) and that is probably the easiest way. You can also contact me through Twitter or on the IntelligentSpeculator Facebook page:) I answer most questions directly but there are some cases where I feel (after confirming it’s ok) that the answer would be better answered on the blog:) Here is a question I recently received:

I would be very happy if you covered a small portion of your information on “Closed End Funds”. I know your are not crazy about them, but with your expertise you could give a few pointers. I hope one of your pointers is not “stay away from them” Half my investments are closed end funds, and its hard to find people that talk about them. I do have access to CEF connect and a few other websites, but I like to read what other people have to say about them. I have been doing good in them, not a lot of growth but a lot of dividends.

Indeed, I’m not crazy about such funds but I’m not opposed to the idea either. I’ll start off by explaining what I’m talking about here. Generally, funds that trade on exchanges are of two kinds:

-ETF’s, ETN’s, etc
-Closed End funds (CEF’s)

I generally invest in ETF’s but they are not necessarily superior. They are mostly different. The main distinction of course is that CEF’s do not accept new “investments”. It seems like a small distinction but it makes a world of difference.

If you take an ETF such as SPY (S&P500), you will be able to buy unlimited number of shares if you’re willing to pay $0.01 over its value. Why? Because those selling to you will simply ask the ETF issuer (SPDR) to create new units which it will invest. It’s a simple process but it ensures that ETF’s would not (except for extreme situations) deviate from their actual value.

Take that possibility away and you suddenly see what CEF’s are like. Someone wanting to buy 1000 shares will need to find a seller of 1000 shares on the market. That could end up happening at a lower or higher price.  Seems like a decent downside right? In a way, yes. Why would a manager want to launch a fund as a CEF instead of an ETF? There are actually several possible reasons:

-Taking new investments every day is fine if a fund owns extremely liquid S&P500 stocks but can be a problem if the fund owns less liquid assets such as fixed income, illiquid securities, etc. The manager might prefer not having these daily inflows and outflows
-In general ETF’s must disclose their holdings, trades, etc. That is fine if you track a fairly public index (like the S&P500) but not great if you’re trading a more active, secret, prop strategy.
-Managing a CEF also gives the manager the possibility to use leverage (it’s possible with ETF’s but much more tricky to do) which many funds use to generate higher income yields, etc.

Is It Still Possible To Trade Closed End Fund’s?

Of course, trading CEF’s is possible, there is simply an added level of complexity. There are a few things to look out for.

-Volume (the higher the trading volume, the tighter spreads you should see which will help a lot)
-Spread to NAV: even closed end funds will publish the daily NAV (net asset value) and you can see where the fund was trading compared to its NAV. Look at such a numbers for a few days or even longer and you will get a feel. Some funds consistently trade at a 10% discount for example so you know that if you’re able to sell your shares at a 5% discount you’re actually doing well. Others would be trading at a premium, etc. It really varies from fund to fund (because it becomes mostly based on supply vs demand) but can change over time of course.

Do You Trade Closed End Funds? 

image credit: WSJ

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