Risks and Rewards Abound for Closed-End Funds

Attorney Advising Disclaimer

Closed-end funds (CEFs) can be popular vehicles for portfolio diversification in the long-term, although these funds come with certain volatility risks.

CEFs are primarily designed for clients with longer-term investment strategies and, in the long run, may very well produce higher rates of return and overall income than open-end mutual funds. This is because CEFs make use of leverage and an ability to buy illiquid assets with higher income potential.

The combination of less liquidity and the authorization of leverage simultaneously increases both the potential payoff and risk involved. For instance, CEFs can produce distributions that exceed open-end mutual fund levels and are often used by experience portfolio managers.

Investment News found that portfolio managers who use CEFs tend to experience more success, though the precise direction of causation—if the relationship even exists beyond mere correlation—is unclear.

Nonetheless, CEFs are fully invested instruments with exchange-traded liquidity, meaning they are easy to buy and sell through public exchanges.

There are certain drawbacks that affect CEFs as a result.

CEFs are more volatile than their open-end counterparts, in part because of the same leverage and strategies that tend towards the less liquid classes over the long-term that are subject to market swings that plague all publicly-traded products.

Leverage can prove advantageous, but also increases risk by increasing volatility. Regulators have also punished firms over the years, fined them many millions of dollars and ordered restitution for abuse or misuse of leverage and transactions related to ETFs and other complex investment products.

In 2013, FINRA issued an investor alert regarding closed-end funds, with suggested questions for investors interested in adding CEFs to their portfolios:

  • Does it fit within investment objectives? In other words, is the CEF's longterm profile right for your strategy. Is the risk level acceptable?
  • What is the fund's investment strategy? Is it leveraged (and, thus, riskier)?
  • What is the sales charge? What are the fees and other expenses associated with the CEF?
  • How does the fund set its distribution rate? Frequent returns of capital may be a warning sign that the fund cannot fund its own distribution.

If you have invested in a closed-end fund (CEF) or with any broker, financial adviser or firm whose solicitation or advisement to invest in a CEF has proven harmful to your investments or interests—for instance, by introducing significant risk that has proven costly into a portfolio with a stated low level of risk tolerance—please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for investigation and consultation.

News: Closed-end funds can offer opportunities, but they come with risks (Investment News)

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