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.

If you ever feel the need to educate yourself first hand on just how bad volatility can get in CEFs, select almost any random fund and look at the chart of the 2008-2009 timeframe.

Taxes

The CEF space is made up of roughly two-thirds municipal bond funds.  This is a good thing and a bad thing – it’s good that assets are spread out amongst many funds yet it’s bad that the best and most popular funds often times trade at high premiums.  Muni bond CEFs are excellent vehicles since income is leveraged and tax equivalent yields are very attractive.

Just keep in mind that any analyst can come out and say that munis are overvalued, or a high profile bankruptcy emerges and many muni fund prices collapse.  Think Meredith Whitney circa 2010, or Detroit and Puerto Rico circa 2013-2014. It pays to work those types of unforeseen events into your total return expectations.

Investors in the taxable income space should take heed that it is almost always better to own non-muni CEFs in a tax-deferred account rather than in a table account due to the high income payouts.  If your fund loses value and you continue to hold it, you cannot use that loss to offset the income you received come April 15th.

Non-Correlation

While there are two sides to the coin on this one, I bring it up primarily from the general pessimism I’ve observed in parts of the equity CEF category.  There are many funds that use options strategies to “control” volatility or “increase” income.  Sometimes they are referred to as “buy write” funds.  The problem is that in real life practice, they will likely underperform an open ended fund during a prolonged uptrend in stocks.  All while charging you a lot of money vs. a plain vanilla Vanguard ETF.  This is the result of the options strategy dragging on the return of the equities during the move higher.

My advice; don’t expect that you’re going to receive an income stream of 8-10% while the fund also mirrors the performance of the S&P 500. If something like that did exist, it would probably have a name such as the “The Enhanced Flying Unicorn Equity Income Fund”.  Rather, seek out equity-only strategies that offer low index correlation thereby giving you a chance at producing alpha over a benchmark.  Otherwise just buy an equivalent ETF.

Premiums

Notice how I left out discounts, since discounts are generally favorable and widespread.  Instead, you will encounter funds that trade at astounding premiums to their net asset value (or NAV).  These funds generally don’t offer anything magical within their underlying portfolio that another fund hasn’t reproduced in some way.  Take the PIMCO High Income Fund (PHK) for example, since the fund trades at an average premium of roughly 60% over its NAV.  Examine the historical NAV performance of PHK’s underlying portfolio alongside the performance of one of it’s sister funds such as the PIMCO Dynamic Income Fund (PDI).  The difference is staggering, and you can even own PDI at a discount.

You can thank me later, but try to avoid over-loved funds that trade at mind blowing premiums.  They have nothing to offer you but the chances that the fund overreacts to exogenous shocks that have nothing to do with the underlying assets. Think Bill Gross leaving PIMCO in 2014. I would hate to be the guy that purchased PHK the day before that announcement.

Conclusion

While its easy to laugh and poke fun at the nonsensical historical events and performance make-up of many individual names in the CEF space.  The risks to your invested capital are very real when caution isn’t heeded.  I believe that anyone can be successful in the CEF marketplace by establishing a disciplined investment game plan and avoiding some of these common pitfalls I mentioned.  There are many more that I can reference, but I’ll save those for another day.