Closed-end funds are investment companies that issue a limited number of shares that trade on an exchange like a stock and buy securities (stocks and bonds) with the proceeds. Each fund has a stated investment objective, typically investing in a particular segment of the market. Some closed-end funds specialize in dividend paying stocks.
Limited Value of Lists
Listing the best funds by name has limited value because lists can change fast based on fund performance. A fund with the best performing three- or five-year record can underperform for the next several years because its star manager has left, the fund has changed its investment policies, another fund has outperformed or the underlying stocks may have fallen out of favor with investors. It is better to have a set of criteria that will help you identify the best funds at any moment and stay with them as long as you are making a profit.
Current Dividend Yield
Stock dividend yields usually stay in the 1 to 3 percent range. Companies in some sectors such as utilities, real estate investment trusts, and select financials pay higher dividends, typically in the 4 to 6 percent range. Some closed-end funds may have even higher yields because they use leverage (borrowed funds) to boost returns. Identifying the highest current dividend yielding funds is a good starting point because it tells you how much dividend income you can expect to collect on your investment right away.
Review the fund’s dividend history to see if the high divided is a one-time event, a fluke, or if the fund has been paying this amount for some time and the dividend is likely to remain at current levels.
Read the fund’s latest quarterly report to see if the high dividend includes a return of principal. Some funds maintain high dividend payouts that include a return of principal which clearly cannot be counted as income because you will simply be getting your own money back, with the fund’s share price falling to reflect the depletion.
Closed-end funds’ unique structure periodically creates situations in which a fund’s stock price drops below its net asset value (NAV) per share – i.e., the stock trades at a discount. A 10 percent discount would be like paying 90 cents for $1 of assets. A discount serves as a safety cushion and adds the potential for capital appreciation: the share price can appreciate 10 percent just to close the discount. Discounts are often created by temporary market conditions such as an imbalance between supply and demand and may not last long – another reason not to rely on a ready-made list.
The larger a fund, the more diversified it can be, and, consequently, the safer your investment. Since managers are often paid a percentage of assets under management, a fund with more assets is likely to attract better managers through higher compensation.
The lower the price per share, the more shares you will end up buying and the higher your commissions may be. In addition, lower-priced funds may not be marginable, which means less demand from other investors and your own inability to borrow against them in an emergency.
Leverage and Other Questionable Practices
Many closed-end funds use leverage (borrowed money) to enhance shareholder returns. Leverage is a two-way street as it can magnify losses as well. Some funds may also engage in options trading or other risky practices to boost returns. As long as the manager makes the right calls, shareholders benefit, but if the manager makes a wrong call or the market turns against him, those practices may cause heavy fund losses for investors.