Closed-end funds have performed well

One of our successful market strategies since the virus turmoil of March 2020 has been the purchase of closed-end funds (CEF’s) that pay high dividends. Let me first explain what they are since they are not nearly as discussed and understood as other funds.

A mutual fund such as American Century’s well known Ultra Fund is one in which new shares are created every time an investor puts money into it. This is called an open-end fund because its size can grow or contract depending upon investor decisions. Including different share classes. There are over 32,000 of these available today for you.

CEFs on the other hand are opened by a sponsoring company with a set number of shares from the beginning. So, for example, if the sponsor creates a fund with 1 million shares at $25 per share, there will never be more or fewer shares available. The sponsor uses the $25 million to purchase a class of investments and then manages them for income, growth of capital, or both, depending upon the fund’s objectives.

Unlike the open-end funds, the share price trades like a stock during the day, and the price depends upon investor demand and supply of shares traded. Because of this, there is always a difference between the traded price and the actual value of all of the positions held inside. If the price is higher than the net asset value (NAV), the shares are selling at a premium, and if lower, at a discount.

For example, last summer, First Trust launched its High Yield Opportunities 2027 Term Fund (FTHY). It is somewhat unusual in that it has an ending in 2027 rather than being of indefinite life. It was initially sold at $20 per share, but since it was designed to pay a monthly distribution rate of 7 percent or higher, its shares rose up over $21 as demand exceeded the fixed supply.

Yesterday, Aug. 24, 2021, it opened at $20.25 and rose to $20.37 by 9 a.m. Central. Since the total asset value on Aug. 23 was $20.85, it is selling at a discount right now. Early on, it sold for as much as a 5 percent premium to NAV. After selling the initial shares, the company borrowed money to invest in more assets and at present, 26 percent of the total assets are due to that leverage.

Therefore, the most recent distribution rate of $0.1494 for the prior month equals 8.88 percent per year at the present share price. This rate rises and falls with the net income earned on the positions inside and the total value of the shares outstanding. What is obvious is that 7 or 8 percent is a really big return compared to available guaranteed rates of interest.

Obviously, because the share prices fluctuate with the overall market and other factors, this is a risker investment (than those with more guarantees) and by reason, it must generally offer a greater return. Last year after the prices of almost all investments dropped so much, the discounted share prices were incredibly cheap and the distribution rates were huge.

As of June 28, 2021, the median discount of all U.S. CEFs was reported to be 2.6 percent. That is not too cheap, but the dividend rates available are still quite generous. Matthew Crouse, CFA, MBA, Ph.D, has written an excellent article on CEFs found in the August issue of the AAII Journal. I commend the American Association of Individual Investors to you as a non-profit organization dedicated to investor education and success. (www.aaii.com).

(Past performance is no guarantee of future results. The advice is general in nature and not intended for specific situations)

Ron Finke is president of Stewardship Capital in Independence. He is a registered investment adviser. Reach him at rcfinke@stewcap.com.