An Investors Guide To Closed End Fund Pitfalls

We frequently come into contact with investors that are intrigued by the unique strategies and high returns offered in the closed end fund space.  The allure becomes even greater when you consider the massive amount of income that CEFs throw off when compared to standard open-ended funds traded at net asset value.  Yet, investors rarely prepare themselves for the downsides that come along with this small corner of the market.  So instead of focusing on all of the great reasons to integrate CEFs in your portfolio, I’m going to focus on a few potential pitfalls that nearly all investors will probably experience first hand owning a CEF. 

Volatility

It can be human nature to want to seek out assets that offer a high return potential. I think they refer to that urge as greed; but investors in CEFs should get well acquainted with volatility as well.  Unfortunately, even if you own a fund made up of 100% fixed-income, it’s not just interest rates you have to worry about, as equity-like volatility will often times transcend to CEFs of all types.

One theory related to this nonsensical volatility is that stocks and CEFs both have three digit ticker symbols.  This could lead to uninformed retail investors being unable to decipher which position to sell, and just liquidate positions all at once.

Liquidity can be a problem in the CEF space and as a result you should be mindful of your fund’s total size and average trading volume. With smaller sized CEFs, even just a few benign retail investors can move the fund significantly; which in all likelihood can ruin your day.  Not many other assets can boast that track record.

Furthermore, just because the market stabilizes and begins to turn around, doesn’t mean your fund will too.  Usually funds will perform their best while nearing the end of a long equity or fixed-income uptrend.  Lending further credence to the notion that retail investors are always late to the party and will jump on any bandwagon. Instead of rejoicing in your funds outperformance, have caution and prepare yourself for the next wave of selling.  It’s only a matter of time before the herd begins to stampede again.

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Disclosure: FMD Capital Management, its executives, and/or its clients may hold positions in the ETFs, mutual funds or any investment asset mentioned in this post. The commentary does not constitute ...

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