Investing

Closed-End Fund Investing: Fear Is Over-Rated

NOTE: I talk about CEF investing for the long-haul. This is different from CEF trading. Trading involves moving in and out of securities depending on the trader’s view of the markets at hand. Trading carries a whole different set of risks I cannot address. Personally, I do not believe that CEFs were meant for holding short term.

In the world of finance, few investments are as misunderstood as closed-end funds. They have a bad rap for being risky, and any advice about them in traditional circles is to avoid them or keep them only as niche holdings. I believe that’s bad advice. When the ultimate goal of your investing pursuits is to provide for you indefinitely in retirement, then owning a portfolio of closed-end funds is one of the least risky strategies you could ever adopt.

This is because closed-end funds actually offer a number of big risk reducers you don’t often hear about. The three I’ll talk about today are diversification, steady compounding, and generating enough income that investors may never have to sell off any of their shares to meet their needs.

Diversification

Closed-end funds are inherently diversified. Just like their younger siblings – traditional (open-end) mutual funds – CEFs hold a basket of hundreds of securities This allows them to diversify across many holdings, sectors, or even asset classes. If you know even only a little bit about investing, you know that diversification spreads out risk because you’re not tied to the success or failure of any one business. Typical investors trust traditional mutual funds and exchange traded funds to provide this risk spreading, yet shy away from CEFs. I’m a bit baffled by this.

What I think confuses most investors is that closed-end funds are priced and behave like regular stocks (just like ETFs) and, rather than move somewhat slowly like mutual funds, tend to move up and down right along with the rest of their asset classes. Sometimes these price swings can be dramatic. There’s a simple way to decrease this kind of potential volatility: own different asset classes and sectors. This can be done quite easily with closed-end funds.

There are several hundred CEFs to choose from in a variety of shapes and sizes, sectors, classes, and investment strategies. Holding several closed-end funds in different fields of operation decreases the volatility in a CEF portfolio, reducing risk right along with it. Diversification is attained within the funds themselves as well as between the funds in a deliberately appointed CEF portfolio.

Compounding

“Work smarter, not harder.” Compounding is known in the investment world as being one of the most fundamental methods of building wealth while taking the least amount of effort. The longer compounding is in effect, the more exponential the results. Price charts don’t show it. Skittish investors jump ship too soon and don’t get a chance to see it in action. Compounding doesn’t work over short time periods – you have to be in it for the long haul.

With closed-end funds, compounding is immediately noticeable. This is because their hefty distributions make it possible to pick up full shares right away, and often. And the sometimes-sorry-looking price charts? Those “lame” prices (as some investors view them) allow CEF owners to compound their shares more quickly because they pick up more for their money.

I did a study last year comparing the growth of a stock, an ETF, and a closed-end fund (all similarly allocated) over a three-year period. My discovery: the compounded growth of the CEF surpassed the price growth of the stock and ETF. I’ve seen it play out in my own portfolio time after time. Compounded growth beats share price growth over the long term, hands down.

This brings up another fear-decreasing aspect of CEF investing: share accumulation. The more units of ownership you hold, the more quickly you compound both growth and income in a self-perpetuating cycle. This occurs even when the markets tank. When you’re in it for the long haul, market corrections cease to be so scary because you see them as opportunities to compound shares even faster. More shares lead to more income, which leads to more compounding, resulting in more growth.

With CEF investing, your focus is different: your eye is no longer on the price, but on how many shares you can accumulate (via compounding) to put you ahead of the game. Share accumulation is CEF investing’s “superpower.” When you know your portfolio has a superpower, you have little reason to be afraid. (Cape and Spandex notwithstanding.)

Perpetual Income

One day, your focus on portfolio growth will be a thing of the past because, in retirement, the focus shifts to providing enough income to live on for the rest of your days. How long will you live after you retire? What – you don’t know?! That’s what scares people the most about their investments: not knowing if they’ll live longer than their money will.

Closed-end funds can provide investors with the ability to create a livable income in retirement without ever having to sell off any shares. (This depends, of course, on how much is invested and how much will be needed to cover living expenses.) An investor can easily attain a rate of 8%-9% on a CEF portfolio.

How much will you need? I’m not a financial advisor, but here are some general rules-of-thumb: Once you figure out how much you typically spend per year (you track these things with a budget, right?), then you can deduct from that what you’ll be receiving from your pension and/or social security, leaving you with how much you’ll require in investment income per year. Take that figure and divide by 8%. That’s approximately how much you’ll need (outside of any emergency savings and cash reserves) to have invested in an assortment of closed-end funds.

When your portfolio generates enough income to live on, you don’t have to sell any shares. The income stream can last indefinitely, removing the risk of outliving your money. Since outliving your money is probably the biggest financial risk you take, that makes closed-end funds one of the biggest risk reducers you can employ.

In my e-book Perpetual Income With Closed-End Funds, I discuss at length the risks of CEFs, both real and perceived, and how to mitigate them. Most of the fear surrounding CEFs stems from a lack of understanding of these investment vehicles. Their bad rap is undeserved. They offer diversification, compounded growth, and perpetual income. When investors come to have a better understanding of closed-end funds, they can invest without fear.

In my next article, I’ll address how the structure of CEFs makes them less risky than most people think.

Disclaimer: I am not an investment professional. I am a strong proponent of sharing ideas, so I write about what I’ve learned in my own investing and research in the hopes of helping others learn as well. Nothing in this material should be construed as professional investment advice. Please do your own due diligence before embarking on any investment strategy to ensure that it is right for you and your own investing goals.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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