3.1. WHAT IS A CEF AND HOW DOES IT WORK?

A closed-end fund (CEF) is a publicly traded pooled investment vehicle (PIV) that raises capital from investors and then invests the aggregate amount collected in a portfolio of securities to help it achieve its investment objective as specified in its prospectus. A prospectus is a document approved by the Securities and Exchange Commission (SEC) that allows a CEF to issue shares. A CEF raises its capital through an initial public offering (IPO), which is the initial sale of a security by a company to the public. The shares represent ownership units. By taking part in the IPO, your investments are included in a combined portfolio that is professionally managed using a common style. Aggregating funds allows you to gain diversification with fractional ownership of a portfolio containing dozens if not hundreds of securities. The common shares of a CEF are listed on an exchange for secondary market trading, enabling investors to trade securities among themselves. Shareholders are represented by an elected board of directors whose mandate is to establish policies for corporate management and oversight and to decide on major company issues such as hiring an investment advisor. The investment advisor manages the fund’s assets, determines its compensation contract, and monitors its performance on behalf of its shareholders. If the board approves, the CEF can issue additional shares typically through a rights offering, which allows existing shareholders the opportunity to maintain their proportional ownership by participating in a new offering.

3.2. HOW DOES A CEF DIFFER FROM A MUTUAL FUND?

CEFs and mutual funds share similar DNA but operate differently. Like mutual funds, CEFs come in a seemingly endless array of types, which includes both stock and bond funds as well as funds that specialize in an individual country or a geographical region. A CEF isn’t the same thing as a fund that has closed. Instead, it mirrors a mutual fund that no longer accepts new investors. Although both are PIVs providing diversification to investors, they differ in many ways.

• Liquidity. One of the major differences between CEFs and mutual funds is how they address investor liquidity needs. Mutual funds must meet the investors’ liquidity needs daily at the closing NAV. Thus, if you withdraw your invested funds, mutual funds use cash on hand or must sell investments to pay you. As an investor in mutual funds, you can invest more money if you choose to do so. Thus, mutual funds are at the mercy of their investors regarding redemptions and additional investments. This characteristic means that investment strategies can be interrupted to create liquidity for redemptions. Mutual fund managers must also accept new inflows regardless of whether they believe profitable opportunities are available.

  Unlike open-end funds, the market for closed-end funds can be illiquid, meaning that you are not always able to buy or sell closed-end funds at will.

  Gary Rudow

  In contrast, as an investor in CEFs, you can’t withdraw your investment directly from the fund. If you want to change your holdings, you must do so through a secondary market transaction with other investors. A secondary market transaction is one in which investors buy and sell shares in the market. As a result, CEF managers can invest in less liquid securities than mutual fund managers because they aren’t required to redeem shares directly at your request. If you want to redeem your investment, you must sell your stake to another investor who is willing to buy your CEF shares. This exchange takes place in the same way you would sell a share of stock. In contrast, CEFs aren’t responsible for redeeming shares in a declining market or required to make new investments in a rising market based on new inflows. This characteristic enables CEF managers to maintain an investment strategy regardless of investor desires to buy or sell shares.

• Intraday trading. You can place an order for CEF shares throughout the day, which is filled at the market price at the time of order execution. By contrast, a mutual fund places all orders at the close of business based on its NAV and any commissions or redemption fees that might apply. Thus, when you place an order for a mutual fund, you know it will be executed at its NAV, but you won’t know this value until after the end of the trading day.
• Expenses. You pay one commission to buy CEF shares and another one to sell them. These commissions are the only transaction-related costs. Unlike many mutual funds, CEFs rarely impose trail commissions or 12b-1 fees, which are assessed against the account annually. A trail commission is an annual fee paid to financial advisors by their clients over the product’s lifetime. A 12b-1 fee is an annual marketing or distribution fee on a mutual fund.
• Use of leverage. CEFs can issue preferred stock or debentures to create leverage in the fund. Preferred stock has a higher claim on fund assets than its other shares and typically pays a fixed dividend. A debenture is an unsecured bond that has a higher claim than preferred stock on the firm’s assets upon liquidation and pays a fixed interest rate. Issuing preferred stocks and debentures magnifies returns – whether gains or losses – and increases the volatility of CEFs relative to mutual funds. The magnification occurs because these securities have a fixed claim on cash flows. When a CEF issues preferred stock and debentures, it has more capital to invest, which increases or levers its investment. As the claims of these instruments are fixed, they don’t share the upside potential generated because of an increased investment base. Any excess return or loss accrues to CEF holders. Thus, some CEFs offer enticing yields because they use leverage.
• Pricing. Although mutual funds trade at their NAVs, CEFs can trade at a discount or premium to their NAVs, depending on the dynamics of supply and demand of their shares.

  Because closed-end funds can trade at discounts or premiums to net asset value, they are more volatile than the equivalent open-end fund.

  Leland Faust

• Management Style. CEFs are usually actively managed. Active management means that managers seek investment opportunities that they believe are likely to outperform the fund’s benchmark. An example of a benchmark would be the return on a market index, such as the S&P 500 index. Active management often entails more trading activity. Thus, increased trading of securities in the fund can result in higher fees and higher taxes for investors. In contrast, some mutual funds are managed passively. Passive management means that managers seek to replicate the performance of the fund’s benchmark. Passive strategies are typically less expensive due to reduced trading, which lowers taxes for taxable investors associated with transactions that produce gains.

3.3. HOW DOES A CEF DIFFER FROM AN ETF?

An exchange-traded fund (ETF) is a PIV typically created to track the performance of a specific index. ETFs are a closely related investment to CEFs. During the ETF creation process, the authorized participant (AP) assembles a basket of securities that tracks a particular index. The AP sells the ETF shares to investors on the stock exchange. Investors can also redeem their ETF shares. With redemptions, the AP buys the ETF shares from the sellers on the stock exchange, returns the ETF shares to the sponsor for the underlying securities, and then puts the securities back into the secondary market. The price of ETF shares on the secondary market closely tracks the NAV of the underlying securities based on these creation and redemption procedures.

In contrast, a CEF issues shares through an IPO producing a fixed number of outstanding shares, which differs from an ETF as the number of outstanding shares in the creation and redemption process fluctuates accordingly. If a difference emerges between the ETF share price and its NAV due to a trade imbalance, as mentioned in Chapter 2, the AP either creates or redeems ETF shares to restore the balance. In the CEF world, which doesn’t include an AP to enforce the law of one price, a CEF’s share price may deviate substantially from its NAV. The law of one price states that the share price of an identical security should have the same price regardless of location when factoring in exchange rates if trading takes place in a free market with no trade restrictions. Thus, CEF prices may deviate from their NAVs, but arbitrage opportunities should eliminate any difference.

Here are some major differences between CEFs and ETFs.

• Transparency. Since most ETFs track a particular index in the same manner as the index is constructed, they have a high level of transparency in terms of holdings and strategy. Thus, you only need to review the holdings of the particular index to determine what securities your ETF holds. In contrast, CEF holdings of underlying securities are less transparent because they are actively managed and traded more frequently. This feature is the primary difference distinguishing ETFs from CEFs.
• Expenses. ETFs are usually passively managed and created to track the performance of a specific index such as the S&P 500 index. An ETF manager buys shares of the securities to replicate the holding of the tracked index. No changes occur unless companies are added or removed from the underlying index. The expense ratios assessed on ETFs are often much lower than on CEFs, which are typically actively managed, resulting in higher trading costs. CEF fund managers frequently focus on specific industries, sectors, or geographic regions. Expenses for CEFs include costs for trading activity associated with an active management style.
• Pricing. ETFs and CEFs differ in how they are priced and sold to investors. Although the NAV serves as the basis for pricing both, an ETF sells at a price near the NAV of the benchmarked index, or the underlying securities held within the fund. By contrast, a CEF can trade at a discount or a premium to its NAV based on the demand from investors. If the market for a CEF has more buyers than sellers, the CEF generally sells at a premium. If the market has more sellers than buyers for a CEF, the CEF normally sells at a discount.

  Shareholders typically want to buy a CEF when it’s trading at a discount.

  Paul Katzeff

• Number of issued shares. Because CEFs are issued through an IPO that establishes the total number of issued shares, they differ from ETFs, whose number of shares varies based on market demand.
• Predictable income stream. Some CEFs such as bond CEFs have a predictable income stream, which is unlike most ETFs.

3.4. WHAT IS THE DEMAND FOR CEFS AND WHAT INVESTMENTS DO CEF INVESTORS OWN?

As Figure 1 shows, the CEF industry reached its peak in 2007 with 663 funds managing $312 billion in total assets. The financial crisis of 2007–2008 had a marked impact on the CEF industry. The number of funds has continued to decline as the overall total assets have remained relatively flat. The lack of growth may be partly explained by the investment’s perceived complexity, potential volatility, lower trade volume, and relative lack of analyst coverage compared to mutual funds. By the end of 2017, the CEF industry had 530 funds managing $275 billion in assets. The increase in total assets between 2016 and 2017 was 4.6%, but this change resulted from increases in asset prices.

Owners of CEFs are like owners of stocks or mutual funds. According to the Investment Company Institute, households owning CEFs are headed by individuals with a college education and a household income above the national median. As of mid-2017, about 3.6 million US households owned a CEF. The characteristics of CEF owners are similar to those holding stocks and mutual funds. CEF investors are older (median age 56) than households owning either individual equities (median age of 53) or mutual funds (median age of 51). Also, CEF owners typically have higher financial assets than mutual funds, with 38% of CEF households being retired.

3.5. WHY SHOULD INVESTORS CONSIDER OWNING CEFS?

CEFs offer many attractive features.

• Convenience. Because CEFs are listed on major stock exchanges such as the NYSE, American Stock Exchange (Amex), and NASDAQ, you can conveniently track the fund’s performance. Just like a stock, CEFs are assigned a ticker symbol that serves as a way of looking up the CEF on many websites. For instance, to learn more about the Allianz NFJ Dividend Interest & Premium Strategy Fund, you would enter the symbol “NFJ” in the search engine at https://finance.yahoo.com/. You can also buy and sell CEF shares throughout the day at the current market price.
• Opportunity to buy shares at a discount. A CEF’s price often deviates from its NAV. Premiums (selling above the NAV) or discounts (trading below the NAV) can result from various reasons, including specific characteristics associated with the fund, investor sentiment, or market perceptions about a fund manager. Investor sentiment refers to investor moods or perceptions of a fund or the market. Funds trading at a discount enable you to potentially recognize a gain if the discount narrows.
• Diversification. Like the lineup of a baseball team that has a variety of players, your portfolio should have different securities and asset classes. Diversification reduces the risks associated with holding a concentrated portfolio helping to gain more consistent returns over the long run. Because CEFs can hold hundreds of different securities, they reduce the impact associated with any individual holding.

  Diversification is an established tenet of conservative investment.

  Benjamin Graham

• Management expertise. CEFs provide management expertise in areas such as research, trading, and money management.
• Access to alternative assets and strategies. CEFs can invest in alternative assets and strategies unavailable within other investment vehicles. Examples of alternative assets include convertible securities, real estate, and commodities. Some examples of alternative strategies include covered call writing and dividend capture strategies.

  – A covered call strategy is an options strategy that consists of selling a call option that is covered by a long position in the asset. This strategy provides downside protection on the stock while generating income for the fund. A call option gives its holder the right but not the obligation to buy the stock at a predetermined price over a designated period. Call options involve a cost to the buyer known as the call premium, which represents the income received by the fund that sells or “writes” an option contract to another party. By selling call options, the fund receives income. If the price of a stock rises, the buyer of the call option can exercise the option obligating the seller to deliver the underlying stock at the agreed-upon fixed price. The return from a covered call strategy comes from cash dividends, income (premiums) received from selling call options, and stock appreciation (or depreciation).

  – A dividend capture strategy enables income-seeking funds to hold a stock just long enough to collect its dividend, which is a periodic cash payment to stockholders. Specifically, dividend capture involves buying a stock just before the ex-dividend date, which is the date after which those buying shares would not be entitled to the dividend, to capture the dividend and then selling the stock immediately after the company pays the dividend.

• Consistent asset base. CEF managers don’t have to worry about managing inflows or redemptions because they establish the funds initially available for investment at the time of the fund’s IPO. Therefore, managers can pursue the funds stated objectives, including less liquid investments without fear of expanding or contracting exposures due to shifts in investor holding patterns. Investors use the secondary market to get or release their holdings. As a result, managers have greater flexibility in selecting investment strategies, which can lead to having long investment holding periods.
• Attractive income potential. CEFs provide distributions from fund holdings on either a quarterly or monthly basis. The distributions include income or dividends from investments and any realized capital gains from selling an investment.
• Ability to leverage. Just as you can buy CEF shares on margin introducing personal leverage in their purchase, CEFs can also use leverage with their investments. Leverage can be structured in different ways, but typical forms of CEF leverage include issuing senior securities in the form of preferred shares or using commercial paper, bank loans, or debt securities. Although leverage can raise the yield if the returns generated on the CEF’s investments exceed the cost of the funds, it can also amplify losses in a downturn. The Investment Company Institute reports that 64% of CEFs used leverage as of the end of 2017. Thus, most CEF managers exploit opportunities to magnify gains. Without such magnification, they might be reluctant to invest resources.
• Lower expense ratios. Because CEFs don’t experience costs associated with either issuing or redeeming shares, they usually have lower expense ratios than mutual funds. These lower expense ratios lead to lower overall fees in the long term.
• Automatic dividend reinvestment. By taking advantage of a CEF’s automatic dividend reinvestment program (DRIP), you can have dividends reinvested automatically at regular intervals. Such reinvestment eliminates trading costs compared to making purchases of additional shares in the secondary market over time and can lead to higher total returns.
• Cash flow generation. CEFs offer higher yields or cash flows than many other investment alternatives. It’s not uncommon to see CEFs yielding 6% to 8% on some funds.

3.6. WHAT ARE THE DISADVANTAGES OR DRAWBACKS OF OWNING CEFS?

CEFs have various shortcomings.

• Secondary market pricing. As CEF pricing is tied to supply and demand, you may sometimes buy fund shares at a premium to the NAV. Thus, volatility in pricing may at times work against you. Unlike mutual funds where pricing is based on the NAV, CEFs aren’t similarly anchored. If a CEF is selling at a discount and demand increases for the fund, the discount may decline. Thus, the decrease in the discount – bringing it closure to its price – offers another component for positive returns.
• Negative effects of leverage. If a CEF can’t generate a return above the cost of funds used for leverage, then you suffer a magnification effect of losses based on the differential. Consequently, leverage is a “double-edged sword” because it can have both favorable and unfavorable consequences.
• Risks of individual CEFs. Each CEF contains its own unique or idiosyncratic risk requiring sufficient research to select a CEF. You must consider the investment strategy of each CEF in evaluating performance compared to its stated strategy.
• Potentially higher sales and management expenses. Compared to no-load (no commission) and index mutual funds, CEFs charge commissions when you buy and sell their shares. Because most CEFs are actively managed, they offer potentially higher gross returns but possibly lower net returns after considering fees and trading expenses.

3.7. WHAT TYPES OF CEFS ARE AVAILABLE TO INVESTORS?

CEFs are classified into five main categories. Most CEFs are bond funds, with most bonds being municipal bonds. Domestic municipal bond funds represent the largest share of CEFs (32%), followed by domestic equity funds (29%). Domestic taxable bonds account for 20% of all CEFs, global/international equity (11%), and bond funds (8%).

• Domestic municipal bond. This type of CEF specializes in municipals bonds, which pays interest that is exempt from federal income taxes and possibly state and local taxes if you live within the municipality under whose authority the municipal bond was issued. Municipal bonds are debt securities issued by cities, states, or other types of municipal governments and help finance public projects such as airports and toll roads. For investors in high tax brackets, municipal bonds may offer a superior alternative to taxable bonds. Domestic municipal bond funds represent the largest single category in the CEF market. As with most bond investments, performance is often tied to the direction of interest rates with an inverse relation existing between interest rates and bond-like performance. For example, if interest rates increase, bond prices typically decrease.
• Domestic equity. This type of CEF invests in common stocks traded on US exchanges. Some specialize in certain industries or geographical regions. Others may distinguish between investment policies within an asset class. For instance, funds can be divided into those that specialize in the companies with the largest market values (large-cap funds) or the smallest market values (small-cap funds) or in between (mid-cap funds). They can also be differentiated based on investment philosophy such as value- and growth-based.

  – Value-based funds focus on securities that appear to offer bargain prices often because of negative market overreaction to current characteristics of these companies.

  – Growth-based funds focus on securities that appear to have strong future earnings growth and are often offered at premium prices.Also included are those CEFs that specialize in dividend-oriented stocks, tax-advantaged stock investments, covered call strategies, real estate investment trusts (REITs), and master limited partnerships (MLP funds).

  When it comes to investing, there is no such thing as a one-size-fits-all portfolio.

  Barry Ritholtz

  – A REIT is a corporation that owns and manages a portfolio of real estate properties and mortgages. These properties frequently include apartments, shopping centers, offices, hotels, and warehouses and produce high levels of income. A REIT’s performance is directly related to that of its underlying properties. Since some REITs trade on the secondary market, they are also influenced by the overall performance of stocks.

  – MLPs are publicly traded partnerships or limited liability companies (LLCs) offering tax-advantaged investments. They provide opportunities for higher cash flow, but performance is contingent on favorable tax policies.

  Overall, CEFs that focus on equity strategies can see their performance influenced by both company performance and general market conditions. Compared to bond investments, equity CEFs are also much more volatile, although they offer the opportunity for higher returns because of their higher risk.

• Domestic taxable bond. This type of CEF invests in high-quality Treasury, government agency, and investment-grade corporate bonds. A smaller portion of the investment portfolio may include high-yield bonds with higher risk. Taxable income strategies include investments in government securities, agency bonds, corporate bonds, convertibles bonds, preferred securities, and senior loans. These strategies focus on income-producing securities.

  – Government securities are debt securities issued by the US Treasury and backed by the US government guarantees for payment. Such securities include bills (mature from a few days to 52 weeks), notes (maturities of 2, 3, 5, 7, and 10 years), and bonds (mature in 30 years).

  – Agency bonds are securities issued by a US government-sponsored enterprise (GSE) or a federal government agency. Examples of GSEs include the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Unlike Treasury bonds, GSEs aren’t backed by the full faith and credit of the US government.

  – Corporate bonds are debt securities issued by corporations and sold to investors to finance a firm’s operations.

  – Convertible bonds are a debt security that offers the holder the chance to convert the bond into a predetermined number of shares of the underlying company’s equity. When the company is doing well, its bonds trade more like the stock’s converted value, but when the company is struggling, the conversion value is rarely a factor in the convertible bond’s price.

  – Preferred securities, primarily known as preferred stock, are a hybrid security with both bond- and stock-like characteristics. Like bonds, preferred stock generates income that is fixed, but like stocks, the firm’s board of directors can suspend the dividends without declaring bankruptcy.

  – Senior loans are commercial loans that take priority over other loans and debt for a company.

• Global/international equity. Global equity CEFs invest worldwide in diversified stocks, including both US and non-US investments. They may also pursue specific stock investing strategies such as focusing on high dividend paying stocks. International equity CEFs invest only in non-US investments.
• Global/international bond. Global bond CEFs invest worldwide in diversified bonds, including both US and non-US investments. These funds offer exposure to international corporations or sovereign debt, which is debt issued by a foreign government. CEFs focusing on international bonds face currency exposure. By investing in an international bond, you’re also investing in a foreign currency. If the foreign currency appreciates, then the domestic return on the international bond increases.

Although offering additional diversification, both global/international equity and bond CEFs have added risk based on differences in accounting standards and laws. Foreign markets are generally less liquid than US markets, and unanticipated economic, political, or social developments can affect market performance.

3.8. WHO MANAGES CEFS AND WHAT ARE SOME OF THE LARGEST CEFS?

Many different companies manage CEFs, with BlackRock, Inc., being the largest. Some fund managers focus on a specific asset class. For example, PIMCO concentrates on bonds, Flaherty & Crumrine on preferred stocks, and Cohen & Steers on real estate. Other companies offer a wide variety of CEFs for bonds, stocks, and other assets, such as BlackRock, Nuveen, LeggMason, and Eaton Vance.

Table 1 shows the 10 largest CEFs as of September 14, 2018, based on net asset value. Nuveen’s AMT-free Quality Municipal Bond Fund (NEA) is the largest CEF with a net asset value of more than $3.818 billion.

3.9. WHAT ARE SOME RISKS ASSOCIATED WITH INVESTING IN CEFS?

Although CEFs can offer an attractive alternative in the pooled investment universe, they also have risks that you should evaluate before selecting a CEF to include in your portfolio. One way to gain the benefits of CEFs while diluting the risks of individual CEFs is to invest in a mutual fund or an ETF that specializes in holding CEFs.

• Higher potential volatility. CEF share values are based on both the value of their underlying assets and investor demand causing CEF shares to trade potentially at a premium or discount to its NAV. The added factor of investor demand causes CEFs to be more volatile than mutual funds. If you suspect that the CEF discount is temporary, this factor increases the fund’s attractiveness. However, some CEFs trade at a discount most of the time. This characteristic of CEFs differs from ETFs, causing some investors to prefer ETFs because they trade at a more predictable NAV. For CEF investing, determining when the discounts are bigger than average can be a profitable strategy. How do you know whether the discount is just temporary or likely to continue? One approach is to use Morningstar, which shows monthly highs and lows for each fund year by year. Another website, the Closed-End Fund Association (cefa.com), provides information on the daily average premiums or discounts for CEFs overall and breaks them out by both stock and bond CEFs.
• Dangers of leverage. Recall that many CEFs borrow money to buy securities to boost yield by adding to the number of holdings in a CEF paying dividends, interest, or capital gains income. As previously noted, leverage is a two-edged sword – it can magnify gains or losses. For example, if a CEF has 25% in leverage (the average is closer to 33% in the CEF universe), for every $1.00 paid per share, you get $1.25 of exposure. Should prices fall, a CEF with 25% leverage would lose $1.25 for every $1.00 invested.
• Distributions. CEF’s income comprises both interest and principal. Why would a CEF return principal? A primary reason is that a CEF may not meet shareholder expectations for distributions. Using its principal can reduce the CEF’s share price over time. How can you track the breakdown of distributions? Morningstar.com includes a distributions tab, which contains a breakdown of annual payouts into four categories: (1) income (interest and dividends), (2) long-term gain, (3) short-term gain, and (4) return of principal capital. Similar information is also available at Cefa.com. For example, in 2017, Liberty All-Star Growth (ASG) CEF had no income, short-term gains, or return on principal capital but had $0.42 in long-term gains.

3.10. WHO SHOULD CONSIDER OWNING CEFS?

CEFs can provide a potentially excellent match for investors based on their goals. CEFs are best for investors who prefer actively managed portfolios and not for those who want “set-it-and-forget-it” investments. They’re also attractive for those who are looking for above-average income opportunities and are willing to take on above-average risk. Why? CEFs offer income investors high yields, which often result from financial leverage and generous distribution policies with regular payments. Despite higher-income potential than many mutual funds and ETFs, CEFs investors may face substantial price volatility, lower total returns, and less predictable dividend growth.

3.11. WHAT DOES THE FEE STRUCTURE LOOK LIKE FOR CEFS?

At the time of issue, most CEFs charge a load, which is an upfront sales charge. The typical load is between 4.5% and 5%. After issuance, CEFs trade in the secondary market so you can view the commission costs of buying or selling as a part of the fee structure. Because both CEFs and mutual funds have expenses, you can compare their expense ratios with expenses measured against average net assets. CEFs that issue debt to achieve leverage report interest expenses as part of the expense ratio. Many leveraged CEFs assess management or administrative fees against both borrowed money and net assets.

3.12. WHAT METRICS CAN BE USED TO EVALUATE A CEF’SPERFORMANCE?

In evaluating a CEF’s performance, you should consider many factors beyond just its return, which is the change in share price over a certain period. Here are some important metrics.

• Total returns. A CEF’s total return includes both the change in its NAV and any distributions occurring over the investment period. The distributions including income and realized capital gains are an important part of the CEF return. Distributions are taken directly from the NAV, which proportionally reduces the NAV. For example, the Liberty All-Star Growth CEF (ticker ASG) had a third quarter 2017 price return of 8.61% and a NAV return of 3.91%. As of October 5, 2018, its one-year return based on price is 27.30%, while its one-year return based on NAV is 19.77%.
• Performance relative to an objective. CEFs have different levels of risk. A CEF that focuses on high-yield issues usually has more risk than one that concentrates on investment-grade municipal bonds. With higher risk, greater return should occur. Remember that the CEF’s prospectus and its shareholder reports delineate its investment objective. Morningstar labels the objective of Liberty All-Star Growth CEF as mid-cap growth. A mid-cap strategy focuses on a company with market capitalization of between $2 and $10 billion. Growth securities tend to have strong prospects for earnings growth. Morningstar’s Mid-Cap Growth index had a price return for the corresponding period of 4.79% and a 2.17% NAV return. Liberty’s returns were greater by both measures.
• Leverage ratio. The leverage ratio is the ratio of total assets to the total value of equity invested in the CEF. Total assets consist of total equity, preferred stock, and debentures. You can view the leverage ratio as a multiplier that magnifies the return on the CEF’s assets. The magnification of returns can go in either direction. A multiplier of 2 would imply that a 10% (−10%) return on assets converts to a 20% (−20%) return on investor equity. Liberty does not lever its returns.
• NAV versus price. Because a CEF’s selling price may differ from its NAV, a simple comparison of NAV over time doesn’t represent actual returns. The size of the gap can vary over time, which affects the return actually earned. For example, if the NAV is $100, but the fund is selling for $95, the fund is selling at a $5 discount. If the NAV increases to $105, but the fund only grows to $97, the discount widens to $8. So while the NAV has increased by 5% (an increase from $100 to $105), the actual return is the change in price, which increased by 2.1% (an increase from $95 to $97). For Liberty, on October 5, 2018, its price was quoted at $6.21 with its NAV at $6.13, which indicates that it was selling at a premium to its NAV.
• Distribution rate and stability. Because distributions constitute an important part of CEF returns – often several times greater than that of mutual funds – you need to evaluate both the stability and sustainability of fund distributions. Stability is important because many CEF investors count on steady cash flows from their fund. You can analyze sustainability by comparing the level of CEF earnings compared to its distributions. As long as the earnings are more than the distribution amount, the fund earned its distributions during the evaluation period. For 2017, Liberty distributed a long-term gain of $0.42.
• Liquidity. You need to make sure that the CEF you select has sufficient trading volume, which indicates greater trading efficiency. Those CEFs with less liquidity are likely to experience a wider gap between their bid price (the price at which an investor can sell a CEF) and ask price (the price at which someone can buy a CEF).

3.13. WHAT SELECTION CRITERIA SHOULD INVESTORS USE BEFORE BUYING A CEF?

You should consider the following criteria when choosing a CEF.

• Type of fund. You first need to decide what kind of exposure you’re trying to get from a CEF. Are you looking to gain broad market exposure? Are you seeking international geographical diversification? Are you trying to lessen your tax liability? Are you hoping to increase or decrease the overall portfolio’s risk? Answering these questions should help guide you to the fund that meets your needs. Investor services such as Morningstar (http://news.morningstar.com/CELists/CEReturns.html) are helpful in identifying funds and their associated characteristics. As identified in the previous question, Liberty All-Star Growth CEF is a mid-cap growth fund.
• Pricing relative to NAV. You’re likely to benefit most from buying a CEF that is selling at a large discount, rather than a premium to NAV. Under this scenario, you benefit not only from the CEF’s holdings increasing in value but also if the discount to NAV decreases during the holding period. CEFs often trade at discounts that can reach 10% to 15% of their NAV, which offers a potential built-in return should the discount narrow. You need to look at a CEF’s current deviation from NAV relative to its historical deviation. This difference can give you a sign if the CEF offers a potential opportunity to invest should the spread between the price and NAV be wider than usual. In the case of Liberty, as mentioned in the previous question, its price was quoted at $6.21 with its NAV at $6.13, which represents a premium of 1.31%.
• Performance history and potential. Although past performance is not indicative of future results, seeking out managers who have an established track record of superior performance could be a wise move. The manager’s reputation and the nature of the holdings influence potential success.
• Leverage. The more debt a CEF holds, the higher is its financial risk. If used successfully, leverage increases return. However, if the fund isn’t performing well, leverage can magnify losses.
• Expenses. As a CEF investor, you have to cover the costs of fund management, which typically are between 1% and 2% of your total investment. You’re also responsible for commissions on trades and fund expenses. Liberty’s expense ratio in 2017 was 1.26%.

3.14. WHY DO INVESTORS OFTEN COMPARE THE MARKET PRICES OF CEFS TO STOCKS?

CEFs have many characteristics similar to common stocks.

• Pricing. The cost of CEFs is determined relative to the fund’s NAV based on supply and demand factors. Thus, a fund’s price can be above (selling at a premium) or below (trading at a discount) its NAV. CEFs and stock are priced similarly.
• Trading strategies. You can use stock trading strategies such as market or limit orders for CEFs. A market order is a request to buy or sell a security at the best available price in the current market. A limit order is an order to buy or sell a security at a specific price or better. You can also sell CEFs short, which involves borrowing CEF shares from your broker who sells them on your behalf. As a short seller, you hope for a decline in CEF share prices so that you can later repurchase the shares at a lower price. Thus, a short-selling strategy profits when the market price of the shares declines. You sell high and buy low.
• Personal leverage. You can also buy CEFs on margin by combining your own money (equity) and borrowed funds. Margin trading involves using borrowed funds obtained from a broker to trade a financial asset such as a stock or CEF, which serves as collateral for the loan. Using personal leverage through margin trading can magnify gains or losses. By using margin trading, you can buy more stock than you’d normally be able to purchase. The Federal Reserve Board sets the rules for margin requirements. The Federal Reserve Regulation T states that an initial margin must be at least 50% of the value of the total investment. An initial investment of at least $2,000 is required for a margin account, although some brokerages require more. Assume you invest $10,000 in a CEF of which $5,000 represents your investment (initial margin) and $5,000 represents a loan. If the fund value increases to $12,000, then your investment rises to $7,000, which represents the difference between fund value ($12,000) and the loan amount ($5,000). So, although the fund rose in value by 20% from $10,000 to $12,000, your investment increased by 40% from $5,000 to $7,000.
• Real-time pricing. In a similar manner to stocks, a CEF’s purchase or sales price is based on real-time pricing. You know at the time of order submission the price at which you can buy or sell shares. In contrast, as a mutual fund investor, you don’t know your purchase or sale price until the end of the day trading.

3.15. WHY CAN CEFS TRADE AT A DIFFERENT VALUE − A PREMIUM OR A DISCOUNT − FROM THEIR NAVS?

The pricing of CEFs is similar to that of stocks in which supply and demand dictate price. However, what causes pricing for CEFs to differ from their NAVs?

• Perceptions. Given that supply and demand affect pricing, public perception can influence demand. For example, if market participants perceive that the CEF offers exposure to an attractive but scarce asset included in the CEF, demand may drive the price to sell at a premium. Conversely, a CEF could sell at a discount if investors perceive that they may be subject to taxes caused by a future realization of a large, unrealized capital gain.
• Activist investors. Activist investors – those who buy shares with the goal of creating a major change – are attracted to CEFs trading at substantial discounts with the intention of forcing management into concessions that result in better returns. These strategies could include share liquidation or support for a merger with another fund.
• Behavioral biases. CEFs may trade at a value different from the NAV because of investor sentiment, driven by the irrational behavior of primarily small investors or those who have little money to invest. Sentiment or “mood” reflects an overall level of optimism or pessimism toward the CEF, which is independent of its actual value. Nonprofessional investors are more inclined to be motivated based on sentiment because they are more prone to behavioral biases, such as being influenced by the mood of the market, than professional investors.

3.16. HOW ARE CEFS REGULATED?

In the United States, CEFs are subject to SEC registration and regulation. CEFs are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act. CEFs are also subject to the Securities Act of 1933 and the Securities Exchange Act of 1934. The Investment Company Act regulates the organization of companies, including mutual funds, which engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public.

3.17. WHAT TYPES OF SECURITIES ARE CEFS PERMITTED TO HOLD?

The CEF’s board of directors sets the fund’s investment objectives and policies as long as they don’t conflict with regulatory restrictions. A CEF must disclose its investment objectives in its prospectus, its principal investment strategies, and any restrictions on the types of investments it may make. The Investment Company Act of 1940also requires that the CEF identify if it will be “diversified” or “non-diversified.” Because shares of CEFs aren’t redeemable from the issuing company, fund managers have the flexibility to invest in less liquid securities. These securities may include thinly traded securities such as those from less developed exchanges or less liquid markets, as well as municipal bonds and small companies that aren’t widely traded. CEFs can also invest in private start-up companies funded by venture capital, which is a form of private equity financing typically associated with start-up companies. Venture capital has high return potential, but also high risk.

3.18. WHAT RESOURCES ARE AVAILABLE FOR LEARNING MORE ABOUT CEFS?

Here are some useful resources for gaining additional information about CEFs.

• Barron’s (http://www.barrons.com/mdc/public/page/9_3040-CEFmain.html) provides market prices as well as NAV and premium/discount figures for all CEFs tracked by Lipper, Inc. Although all pages are updated daily, some funds only provide NAVs weekly.
• Morningstar (http://news.morningstar.com/CELists/CEReturns.html) has charts and analysis of CEFs.
• The Closed-End Fund Association (https://www.cefa.com) lists CEFs and their recent performance. You can also find the percentage of a fund’s assets that are leveraged or purchased with borrowed money.
• The Investment Company Institute (https://www.ici.org/research/stats/closedend) supplies statistical data about CEFs including investor demographics.
• The US Securities and Exchange Commission (https://www.sec.gov/fast-answers/answersmfclosehtm.html) provides regulatory and general information about CEFs.

3.19. TAKEAWAYS

CEFs provide an alternative framework for investors to gain access to a diversified pool of assets with distinctive features from other PIVs such as mutual funds and ETFs. In particular, CEF managers can pursue strategies involving less liquid assets than those ordinarily associated with mutual funds because CEFs have a fixed number of shares that limits liquidity concerns related to redemptions and new issuances. Unlike mutual funds and ETFs, supply and demand relations can affect CEF pricing relations, which can differ from the NAV.

Like all investments, CEFs have risks. Because their price isn’t directly tied to the NAV, you can experience a negative return on your investment if a CEF sells at a deeper discount over time despite an increasing NAV. If you hold a CEF for a short period, the potential exists for fees to swamp any superior returns compared to mutual funds and ETFs. However, assuming you’re a savvy investor who has done your homework, you may take advantage of a great opportunity in the CEF market by identifying a fund with high distributions, a closing gap between a discounted price and NAV, and high leverage that magnifies positive returns that can result in superior CEF returns.