Use Caution With Closed-End Funds

Closed-end funds, which took a drubbing during the financial crisis, have been making a modest comeback.

Total assets rose 1.7% to $239 billion last year, though they remain well below the precrisis record of $313 billion, set in 2007, according to the Investment Company Institute.

There's no mystery why some investors are willing to give closed-end funds another chance. In a world where interest rates are hovering at record lows, closed-end funds are one of the few asset classes where one can find a tempting yield.

The average distribution rate for these funds—which issue a fixed number of shares that trade on an exchange, like stocks—is 7.1%, according to Morningstar.

"Closed-end funds can be an excellent way to generate income," which is "the Holy Grail for retirees," says Cara Esser, a closed-end fund analyst at Morningstar.

But Ms. Esser warns that closed-end funds can be "risky" and should account for a relatively small percentage of a portfolio—certainly no more than 25%, and for most, much less.

For investors willing to give closed-end funds a try, there are some things they must know—including how these funds operate, and how that operation influences the way they trade.

Unlike mutual funds, which are traded at the end of the trading day, closed-end funds can be bought at will, like stocks. Sponsors issue a limited number of shares, and authorize follow-up offerings, to keep up with demand. When ready to sell, investors must find a buyer in the secondary market.

The fund itself rarely has to sell underlying assets to meet the demand for redemptions. That freedom allows closed-end funds to invest in less-liquid markets, such as municipal bonds and emerging-market securities, says Ms. Esser, adding that about 250 of the 630 closed-end funds in the U.S. are focused on muni bonds. Due to their relatively small size—the average closed-end fund has $300 million to $400 million in assets, according to Ms. Esser—they can get in and out of illiquid markets faster than larger investment vehicles.

That structure shapes the trading of closed-end funds in several ways:

Price vs. net asset value. There's a difference between the fund's net asset value, which reflects its underling holdings, and the share price of the fund itself. Those premiums and discounts to NAV can work both for and against investors—depending on whether they are buying or selling at any given moment.

"Ten years ago, I saw premiums and discounts to net asset value as wide as 20%," says Christopher Begg, an adjunct professor at Columbia Business School and chief investment officer of East Coast Asset Management. Though those discounts and premiums have been reduced, he says, they still exist.

In some cases, share prices "have nothing to do" with NAV, Mr. Begg says. Instead, they reflect demand for a particular fund, which can be influenced by the reputation of the portfolio manager and other considerations not directly linked to the underlying assets.

"Closed-end funds can be an interesting source of income, especially when you can buy them at a discount to net asset value," says Mr. Begg. His firm, which manages $500 million in assets, doesn't currently include any closed-end funds, however.

The risk, he says, is that when an investor is ready to sell, the share price of the fund may be trading at a discount to the NAV.

Leverage. Closed-end funds also can make use of leverage, or debt. By law, closed-end funds can borrow between two and three dollars for every dollar in equity—amplifying their returns when bets go well, but compounding their problems when investments go bad.

Income Quality.The income closed-end funds report reflects many things—from the dividends and interest of its underlying assets to one-time boosts like capital gains taken when they sell those assets.

Ms. Esser says funds report the composition of their income, and investors should pay close attention. Funds that count on one-time boosts such as capital gains to support distributions are suspect, she says.

Ms. Esser likes the Virtus Total Return Fund (DCA). The fund, which operated under a different name until last year, lost a lot of money in 2007 and 2008. But it brought in a new adviser, Virtus Investment Advisers, which narrowed the fund's discount to its NAV to 9.5% from 13%.

The fund cut its distribution rate in half to 7.5%, in line with peers, because it stopped counting some income, such as capital gains, toward the payout. The distribution now comes entirely from earned income.

"Closed-end funds whose distributions reflect the earned income of their underlying holdings tend to generate more sustainable returns," Ms. Esser says.