3 Mistakes To Avoid When Choosing The Perfect Closed-End Fund

The closed-end fund marketplace is one of over 500 offerings that span virtually every global asset class. This makes the landscape both ripe with opportunity for savvy participants and consequently laden with pitfalls for those who misunderstand this vehicle.

Closed-end funds should be considered advanced tools by their nature. These funds are typically more expensive than an open-ended mutual fund or ETF and often target sophisticated investment strategies. The use of leverage and options create a myriad of risks that must be understood and managed.  Furthermore, the industry-specific rules allow for a much different experience than conventional vehicles.

The following are numerous pitfalls that investors often make when choosing a closed-end fund to complement their portfolio.

1. Dividends As Return of Capital

Most investors enter the CEF marketplace for the yields. After all, these funds often pay dividends that are many orders of magnitude greater than an unleveraged fund. The board of directors for each closed-end fund are typically the ones who set the yield and it is subject to change at the board’s discretion.

However, unlike a traditional ETF or mutual fund, a CEF can pay out far more than it is actually earning in income from the underlying assets. They call this excess “return of capital” (or ROC for short) and it should be viewed as an undesirable trait among funds that rely heavily on this feature.

Return of capital means the fund is essentially just paying money out of its asset base to meet its distribution schedule. It’s like the yield is a mirage altogether. Something designed to lure investors who like the thought that they are getting a big paycheck each month or quarter.

Now return of capital isn’t always a bad thing. Some CEFs are able to generate most of their yield and need a small boost to get them all the way to their managed distribution. However, it’s most egregious when 80% of the income or more is manufactured using this method.

I have seen this trait most often implemented in equity CEFs that own stocks that generate very little income. For example, the GAMCO Global Gold and Natural Resources Fund (NYSEMKT:GGN) is a prime user of return of capital to pay its hefty income stream. That type of misdirection immediately disqualifies it for my style of investing.

2. CEFs Masquerading As Expensive Index Funds

Closed-end funds are usually much more expensive than traditional ETFs, index funds, and even some actively managed mutual funds.  Their annual expense ratios usually start near 1% on the low end and can reach past 3% in some instances. As such, you should have the expectation that they are implementing a unique strategy to create alpha above a passive benchmark.

While many CEFs are engaged in just that endeavor, there are some that quietly act very similar to a passive index. If the top 5 holdings in your CEF are eerily familiar to a sector-style ETF or a strategy that you can own for a fraction of the cost, then don’t buy the fund. This is especially true if the CEF isn’t actively implementing leverage or some other unique differentiating factor to earn its larger fee.