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How to invest in closed-end funds

TradingPub Admin | June 12, 2013

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If you want some free trading education on how to invest in closed-end funds, you have come to the right place.

CEFs are one kind of mutual fund, and get their name from the fact that they only issue a finite number of shares. This aspect is what differentiates them from open-end mutual funds, which can issue additional shares after having an initial public offering.

CEF investment qualities
These funds are generally actively managed, meaning that they harness a team of professionals to make investment decisions. After a CEF sells its first units of ownership in its IPO, the investment vehicle can use the capital generated to purchase various financial instruments.

According to a Wells Fargo Advisors document called "A guide to investing in closed-end funds: What you should know before you buy," a CEF might invest in equity and debt based securities including corporate and municipal bonds, derivatives, commodities and financial instruments that provide exposure to activities happening in emerging markets.

How to invest in CEFs
One very important factor you should observe when considering a CEF for investment is whether its shares are trading at a discount, meaning less than the net asset value, or a premium, meaning more than this key measure.

Such a distinction is so important that John Waggoner, a personal finance columnist for USA Today, wrote in a recent opinion piece that investors should never pay a premium for a fund. He notes that some investors have been willing to pay for funds run by legendary bond investor Bill Gross that were trading 65 percent higher than their NAV.

Key concern: discounts and premiums
One good way to evaluate the deal you can get on a particular CEF is to request the average annual discount that it has had since inception, according to The Wall Street Journal. This historical figure can then be used as a benchmark when evaluating any existing discount.

Funds such as these have a strong tendency to move back to their long-term discounts, the media outlet reports. What this means is if the CEF has been trading at an annual average of 5 percent less than its NAV since it was opened, and this year the gap has widened to 10 percent, you can use the lower price of the security to your advantage. You have the opportunity to purchase it at the current discount, and then later sell it when it moves back to the historical value.

Waggoner emphasized that focusing on obtaining CEFs for the best deal will not hurt, but that buying a fund at a discount will not ensure profitability. There are some times when there is a good justification for these securities selling at a price below their NAV.

Key performance indicators
Aside from whether or not the fund is currently trading at a premium or discount, there are other key figures you should check. For example, the yield that the CEF is currently paying is an important consideration, according to The Wall Street Journal.

Income is a major reason that investors flock to these funds, as they frequently offer a higher yield than open-end mutual funds, the media outlet reports. If you are looking to buy a CEF because you want to enjoy income, it is important that you purchase one that has a yield above that of U.S. Treasuries.

Other considerations
The guide provided by Wells Fargo notes that while factors such as yield and discount may be important, you must also assess some personal variables such as time horizon and risk tolerance before purchasing anything. Due diligence is key, and this means that any transaction should come after you conduct a thorough review of all available documents.

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