Closed-end funds in the simplest possible terms

Side benefits of having a blog: when you get tired of trying to explain a concept, you can use the platform to explain it in the simplest possible terms.

Let me also begin with a promise. As this essay gets more involved, I will let you know at those points, so you can say “nah, we done now” rather than go further. It looks long. It need not be.

Because we live in dumbth nation, I must include the disclaimer that nothing herein should be construed as investment advice; that all investments should be evaluated through one’s own research; and that the aim of this article is to promote the understanding of how investments work, not to encourage investment in any specific security or security type. And that, therefore, the author assumes no liability or responsibility for nincompoopery in anyone’s investing.

God, how I hate that. One day tire irons will come with warnings saying “DO NOT EAT.”

A substantial part of my investing energies goes into closed-end funds, which many people seem not to know exist. I try to explain them, and how they differ from conventional open-end mutual funds, and eyes go vacant.

All right. This is too simple to be eye-glazing.

Cora, Eve, and Clark offer to invest your money. Each will give you his or her own branded poker chips representing shares. How much each share (white chip) costs depends on the day. Hear out their plans.

If you go with Cora, she accepts your money, manufactures the proper amount of chips, and issues them to you through your broker. Some may be fractional; in fact it’s rare for anyone to hit a perfectly round number. Cora will invest your money, along with that of others, according to guidelines she publishes. Cora’s value lies in her perceived market savvy and expertise. She has a prestigious degree, lots of whizbang charts, and other marketing hoo-hah to convince you to buy and hold onto her chips.

The price of a Cora chip is based on the total value of her investments divided by the number of her chips that exist, so that changes every day and is determined about two hours after the markets close. Sometimes the government makes Cora pay you dividends or capital gains, so they can get tax from you sooner. To fire Cora, before the trading day is over you tell your brokerage to sell however much $ worth of her chips. This occurs at the price that is determined after market close. Cora gets your chips back and melts them down, then pays you based on that day’s price. If you don’t place your order with the brokerage before market close, your order happens tomorrow. Note that you lack firm control over the price you pay. Market went nuts in last five minutes? Could be good for you. Could be bad.

 

Eve has a different plan. She is like Cora in that she invests other people’s money, and she does publish a base chip price determined in the same way Cora does, but you don’t do business directly with Eve nor at that base price. You pay a brokerage to find someone to sell you his or her Eve chips. The amount of Eve chips stays the same, unless Eve makes one of her rare new chip productions.

Eve’s guidelines say that she has to mimic a given stock or bond index to the best of her ability. Therefore, the market price never gets far from the base price Eve calculates (referred to as an NAV). Eve pays regular dividends, and you have to pay tax on them. Unlike Cora, though, who coughs up the tax bomb as a Christmas present, Eve pays them regularly throughout the year with little suspense. Because Eve gets a small fee for her work, she never quite beats the index she tries to mimic. But she comes damn close without fail and, about 60-70% of the time, Eve’s results pummel Cora’s.

Cora gets very good at filling up her regular chipowner reports with great excuses for why she again underperformed her target index. Oh, and Cora’s annual fees are ten times Eve’s. She hopes chipholders won’t stop to think about that. She also hopes the people holding her chips won’t stop to ask why, during a year in which she actually lost them money, they still had to pay a bunch of tax on gains. If bugged about it, she blames the government and the law.

 

Clark’s program resembles Eve’s. When he started up, like Eve did, he made a bunch of chips and sold them into the market through an investment banker; thereafter he doesn’t create or destroy or transact them. Like Eve’s, you buy Clark’s chips from someone who wants to unload theirs. Because Clark is not trying to mimic an index, his chips’ market price can swing well above or below the base price he calculates. His job is as hard as Cora’s. He can screw up.

Clark only invests in bonds with moby payouts, and he buys hundreds of them. High-risk bond issuers have to offer high interest to attract buyers. Because some are at risk of not being repaid, Clark spreads the money out very thinly. He pays chip owners high yields, often 10-12% per year in monthly installments. Sometimes the money comes out of interest on the bonds, sometimes out of profits from selling bonds, and at times out of uninvested cash. Clark’s chip owners will have a shit fit if he cuts the payout, so he does his best to avoid that. However, Clark is human, and if he screws the pooch, the payout could go down. If he does that, his base value might go down, and his chips will probably trade for a lot lower price than his base value.

 

Cora manages a conventional open-end stock mutual fund. Eve manages an exchange-traded stock index mutual fund. Clark manages a closed-end bond mutual fund.

If you want to, keep reading for more details. If you just wanted the simplest possible explanation that I promised you, I hope I succeeded, and thanks for giving me a chance to explain it.

 

It’s important to know what the terms mean. Without definitions, one wanders blindfolded through an explanation.

A security is a (nowadays mostly virtual) piece of paper that says you own something. In conventional investing, one buys shares of securities in pursuit of growth (one hopes to sell them later at a profit) and/or income (one wants to be paid just for owning them). Sometimes both goals are in play, and obviously anyone seeking income at least wants his or her original money back in the end.

There are other rational goals, but those are the two big ones. It’s foolish to buy securities without knowing what you want from them.

What are securities? Many types: common stocks (you own a little piece of a corporation), bonds (you own a little piece of a loan), preferred stocks (you own a weird hybrid of stock and bond), publicly traded partnerships (like stocks, but instead you own a little piece of a limited liability company), mutual funds (you own a little piece of a whole bunch of securities someone else picks out), and some more.

If you are following the main thrust of this post, it has registered with you that this makes a mutual fund a security of securities. True.

Most individuals and many professionals lose money buying individual stocks. Buying individual bonds is sometimes risky and usually cumbersome for individual investors. Thus, someone proclaims him or herself an expert, files an ocean of paperwork, and says: “I will invest other people’s money according to some preset guidelines. I know what I am doing.” This results in what we call a pooled investment–as in ‘your money is pooled with others’– commonly called a mutual fund.

The three major sorts of mutual funds all work differently. That’s why I began this article with that poker chip explanation. I believe it is the least understood, most-needed-to-be-understood aspect of modern personal finance. I believe that understanding liberates you from bad decisions. Here’s the less simplified version, which I hope the first example made easier to follow.

First, you need to know what is meant by ‘ticker symbol.’ Stocks, mutual funds, and stock-like securities all go by shorthand labels called ‘ticker symbols,’ consisting of letters. Microsoft is MSFT. Alaska Airlines is ALK. Long ago, Continental Illinois Bank was CIL. RCS is the Pimco Strategic Income Fund, a closed-end bond fund.

Conventional mutual funds (CMFs; Cora’s fund) work like this. All shares are bought and sold through the fund manager or its agent. All CMFs are distinguished by five-letter ticker symbols ending in X. Thus, FCNTX happens to be Fidelity Contrafund. VFINX is Vanguard S&P 500 Index Fund, and so on. Thousands exist. They usually trade by dollar amounts rather than numbers of shares, which are recorded to three decimal places. (Going back to our starting example, imagine Cora, Eve, and Clark’s chips stamped with their ticker symbols.)

When you buy CMF shares, the company accepts your money and issues (creates) the shares to you. When you sell them, the company redeems (destroys) the shares and pays you their market value, which is based on that percentage of every security the fund owns. A CMF’s share price is referred to as its net asset value (NAV). That distinction matters because they are not stocks and must not be viewed as stocks. The number of shares of a CMF in existence thus changes daily.

If CMF shareholders sell (redeem) enough shares at once, the company may not be able to pay the sellers from free cash. Those following along very well have registered that the company might have to sell some of its security holdings to fund very large redemptions, thus demonstrating one of CMFs’ biggest problems: their mechanics can force them to trade when its managers might not prefer to do so, which means your highly paid professionals aren’t allowed to use their full best judgment, which in turn is what you (yes, you) pay them for. It’s like a computer managing a baseball game that calls for a bunt even when a slugger–and a lousy bunter–is at the plate. The slugger can only shrug and attempt the bunt, knowing it’s a bad idea.

I used to work for a company that managed CMFs. The big money situation works in both directions. What if a huge pile of money comes into the fund at a time when it’s a lousy time to buy? And yet the fund guideline says that it will be no more than 5% in cash? There is no choice. Disobey their own guidelines and they will be in big trouble. They must pick the least unpromising choices available in compliance with their guidelines. It’s like hiring a contractor when there’s too much work for contractors (or at any time in Portland): all the best options are booked six months out. Only the inferior builders will even come out to look at your job, and they will charge too much for crappy work.

Ever hired a house-sitter? If that person was an adult, you probably set out some guidelines, but ultimately you realized that the reason for having a house-sitter was to have a responsible adult keeping an eye on your place. If the adult could not contact you, or detected an emergency, you would have to trust that adult to do intelligent and prudent things to protect your property. Owning a non-index CMF is like hiring a house-and-pet-sitter but with such extensive rules as to paralyze the sitter’s best judgment. Who hires a house-sitter without trusting that judgment? This is stupid.

Index CMFs, a variation on the above, take the judgment out of the equation by attempting to imitate a stock or bond index (fictional investment portfolio meant to represent some portion of the market for benchmarking purposes). A Standard & Poor’s 500 index fund buys, in proper proportion, all the stocks in the S&P500. If S&P ditches a stock, so does the fund. (This may sound to you like Eve’s method. It is. Think Cora’s chip issuance mechanics combined with Eve’s investing plan.)

In workplace 401ks, an index CMF is often the least doggy of the ten or twelve dogs on offer. And if it’s a conventional 401k, there won’t be an annual tax hit. Most 401k CMF offering lists I have seen were full of mediocre funds. I believe that most are selected by the 401k custodian through kickbacks. I am also convinced that the 401k custodian often pays off the employer’s representatives in order to be selected. It’s the most logical reason for such laggard choices.

Index ETFs represent the same basic idea as index CMFs, but with different mechanics since one buys or sells them on the open market at a price negotiated with another investor by brokers. Either way, the NAV (and thus your price) goes up and down in lockstep with the index. Both charge low fees because this doesn’t take that much brainpower. If Slave Labor & Prostitution, Inc. (ticker: SLAP) gets big enough for Standard & Poor’s to include it in the S&P 500, the index fund managers of S&P 500 index funds will obediently buy the correct proportion of SLAP shares to mimic the new composition of the index. Since Rust Belt Decay Corporation (RBDC) got thrown out of the index to make room, the managers dump its shares. All of them. Eve’s ETF does it this way.

Index ETFs can attempt to imitate bond indices, or in fact any imaginable security index. So can index CMFs, of course, and they do. In the case of bonds, pooled investments represent the primary way individual investors park their money in fixed income (the sophisticate term for bonds, but which includes some other investments that also pay a, wait for it, fixed income).

CEFs, like Clark’s, are the main subject of this article; however, to understand them, one needs to understand how they differ from their lookalikes. Most invest in bonds, but there are stock CEFs and perhaps other kinds. Maybe there are some that invest in partnerships, or preferred stocks, or gold coins. My focus here is on high-yield fixed income CEFs, because I’m impatient and greedy and don’t have much faith in long-term promises or institutions. I have faith in what can no longer readily be taken away from me.

CEFs interest me because if I buy them intelligently, I get distributions amounting 10-12% per year, paid in monthly installments. I may even get a capital gain if I ever sell them–but the goal is not growth. It is income, paid now and not later, which means two things I like:

  1. It’s too late for them to screw my money up or take it back. I got it. Not theirs anymore.
  2. Because I get it now, not later, I can use it now. I can buy more shares now and increase the amount of money that’s paying me that 10-12%.

At this point, I consider CEFs well explained. Everything after this para expounds my experiences and observations, and may herewith wander from the topic. If all you cared about was the topic, school’s out. Thank you!

 

Most people investing in the stock market would figure 12% a reasonable goal, year over year on average. They would accept major declines, and might stay invested for years without having actually locked in most of their gains (i.e. sold the shares). And 12% is in fact a very rational goal based on long-term historic performance. But I want my money now, not later, so that I have it to reinvest.

That’s what I do with CEFs. I buy them, at a discount to NAV where possible. I hold them unless/until they decrease the distribution, or I find better options. If they cut the distribution far enough to make them unattractive, I find better options with ease. I may take a capital loss doing so, but remember that all along–for years, even decades–I got my 10-12%. And all along, therefore, I had that money to use for something else–such as more CEF shares.

Yeah, I paid tax on those distributions…except when I did not owe any. Those CEFs in my traditional IRA were not subject to tax. I got that money every month. When enough of it piled up, I looked over my CEF universe (current holdings plus potential holdings of interest), decided which would pay me the most money without being too overweighted in a given CEF, and bought shares. Those shares then started to pay me money.

Now and then, I’d see a major share price dump in a CEF. I’d go to find out why. Usually it was that they’d cut their distribution, absorbed another CEF, experienced shareholder drama, or otherwise done something excitingly harmful to my pleasantly dull regular payments. Most commonly, I’d just dump the CEF shares regardless of capital gain or loss. I would redeploy that amount into the best available option at the time.

A surprising percentage of the time, thanks to cheapskate buying practices, I’d realize a capital gain from selling the shares. Now that was fun. Pay me monthly for eight years, then a parting bonus for firing you? Yes, please.

This took me minimal work. Every month or two, I’d go to my spreadsheet comprising my CEF watch list. I would update current market values, current NAVs (so I could see whether it was trading at a premium or discount, and what magnitude), monthly payouts, and my own original cost for the shares. The latter numbers were essential to me knowing what I was currently being paid. The rest of the numbers related to what I would be paid if I bought shares now. I would also seek to add a CEF to my universe, searching my brokerage for the best paying bond CEF, then reading up to filter out the ones that seemed unsustainable or outlandish. If it looked too good, probably was. The biggest dog in my universe, after all the updating? I’d cease tracking it. If I actually still owned it, I’d place a sell order. If I knew I could get 11%, why would I even follow something offering 7%? No need.

Some years, the stock market would eat flaming death. Many people would freak out. Many would panic-sell their stock shares, mutual fund shares, everything, eek, the sky is falling, sellsellsell. I would go shopping. When my CEFs looked to be down about 25%, I’d update my spreadsheet and blow every dollar of cash in my account on dirt-cheap shares. I knew what I was seeing was panic, irrationality–and opportunity. I didn’t buy on margin, but I bought with every real dollar that had been piling up. Since I paid less for the shares, I got much higher yields, some almost embarrassing.

I would be paid those grotesque yields for years and years, until they either cut the distribution or I sold the shares.

Eventually I no longer bought separate issue securities at all. With money I couldn’t afford to have bounce up and down to any degree, I bought conservative bond index ETFs. With money I wanted to grow, I put part of it into CEFs, and part into a rough 80/20 mix of small-cap stock and conservative bond ETFs called the 3% Signal. I no longer even cared what high-flying tech stock the pundits touted. I stopped reading financial pundits, none of whom ever paid a penalty for being wrong. I decided that I was never again going to take advice from a Jim Cramer unless he was putting in writing to reimburse me any potential losses. If the market were to crash, I would make a lot of money and it would recover within a couple of years. History supported me.

Only a total collapse of the national economy, including the dollar’s value, would wreck me. If I ever came to believe that was likely, I would have invested in some other way that was immune to such a cataclysm. All those ways are very big bets on very unlikely outcomes. I realized that everyone who bought any form of securities, no matter how preppy he or she talked, didn’t really believe in this impending disaster. I have pure contempt for the concept of professing a philosophy one does not in fact believe, be it religious, economical, what have you. If you believe it, your actions will prove it.

How you invest money you can’t afford to have vanish is what you really think about the economic future. What one says means nothing. If you buy gold, but you leave it on deposit at Edward Jones, evidently you think there is a greater risk of home burglary or theft than of a cataclysm causing Edward Jones to close its offices. If you put money into your 401k, but talk big about how everything is going to be destroyed, you are lying. If you were that sure of your outcome, you wouldn’t put one dime into a 401k even if your employer matched it. Double nothing is still nothing.

There could still be a total collapse that renders everything irrelevant. If there is, it’ll also nullify most of my potential protective measures and screw me (and nearly everyone else) up real bad. It doesn’t make sense for me to prepare for something that has been predicted annually going way back, without happening or punishment for the wrong predictors. It is more logical for me to prepare for recurrences of what has been demonstrated to occur.

I’ll keep collecting my 10-12%.

Advertisements

What's on your mind?

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.