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Closed End Funds (CEFs)
and
Exchanged Traded Funds (ETFs)
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Article >
iShares
and ETFs: Indexed Investment Illusions
Caveat Investor: Just
like any other investment, absolutely never purchase the IPO... too much
hype, and the costs are indeterminable without close study of the
prospectus.
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A Closed End Fund (CEF) is a publicly traded investment
company that invests in a variety of securities such as stocks, bonds,
preferred stocks, real estate, mortgages, royalties, etc. The variety of
sectors, classifications, and geographical representation is every bit
as confusing as it is with traditional funds, but the advantages are
easy to understand. Capital is raised by The
Investment Company through an initial public offering (IPO) of common
stock and the proceeds
are invested according to the investment objectives of the fund. Like a
traditional (open end) mutual fund, a Closed End Fund has a board of directors,
appoints an investment advisor and employs a portfolio manager.
Unlike Conventional Mutual Funds, CEFs do
not issue and redeem shares directly with investors at net asset value.
CEFs are listed on national securities exchanges, where shares of the
Investment Company are
purchased and sold in transactions with other investors, just like
individual company stocks, and most often not at net asset value. Many
Brokerage Firm Statements will list these securities as
"Equities" or "Mutual Funds", not quite in sync with the
purpose or nature of the securities contained within. You should keep
this in mind when you analyze the asset allocation of your portfolio and
adjust accordingly.
Although the number of outstanding shares of a
CEF remain
relatively constant, additional shares can be created through secondary
offerings, rights offerings and/or the issuance of shares for dividend
reinvestment. Existing owners always get
the first shot at new shares, in proportion to their holdings, so they
can choose to protect themselves from any dilution of interest. Again,
vastly different from traditional Mutual Funds.
Many of the advantages of Closed End Funds
are itemized below. it should be abundantly clear when you finish that
this form of Investment Fund has eliminated nearly all of the drawbacks
of conventional Mutual Funds! The two have very little in common.
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Advantages of
Closed End Funds
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Trading Liquidity/Flexibility/Cost: Closed End Fund shares may
be bought or sold at any time during the trading day, just like common
stocks, and share prices will fluctuate. They
are excellent start up investment vehicles for smaller accounts
where diversification would otherwise be difficult to achieve. There
are no penalties for leaving the CEF when the stock is sold. The
only direct cost involved is the commission paid when buying or selling
the shares.
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Efficient Portfolio Management: Unlike open-end Mutual Funds,
where the Manager must constantly deal with cash inflows and outflows, the asset
base for CEFs is relatively stable. Without the pressure of constantly
investing or redeeming securities based on investor demands, CEF
managers are in charge of the fund and use their own experienced judgment
to make investment decisions... uninfluenced by the fear and greed of the
average investor.
This is the key element making this form of
investment so attractive in certain instances and for certain specific
purposes...they are especially suitable for fixed income portfolios and
for the initial development of smaller equity portfolios.
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Leverage IS an Advantage- Closed End Fund managements may borrow
money or raise additional capital by issuing Preferred Stock in
an effort to leverage the productivity of the investment portfolio. As long as the short-term
interest rates paid to the lenders and the dividends paid to preferred shareholders are lower than the net
long-term rates earned by the portfolio, the common
shareholders of the fund will earn higher rates that they would have
without the "leverage".
Rising interest rates aren't
nearly as scary as critics would like you to believe. The manager can
reduce the leverage, and new investments are made at higher yields.
- Leverage is not a four
letter word! All debt is a from of leverage and, without it, you
would probably be peddling to work instead of driving that Mercedes.
Investors should avoid CEF's that have
spectacularly high yields, as this could be a sign of excessive leverage
or other forms of risk. For
the most part though, leverage is a good thing for share owners when it
is managed properly. All corporations use short term and
intermediate term borrowing in their Capital Structure, and the rating
agencies don't seem to care about that "leverage"... until it becomes
excessive. Most individuals are "leveraged" as well. The word
"leverage" sure sounds forbidding, but it's SOP (standard
operating procedure) for most business entities.
Yes, even conventional Mutual Fund Companies borrow money with
Preferred Stock and Bond Financing... it's the way corporations operate.
On the whole, traditional open end Mutual Funds are much more
profitable for their sponsors and salespersons than are the Closed End
Fund variety. They (the CEFs) have been
around for a long time, but are just recently becoming popular with more
knowledgeable individual investors.
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Fund Expenses - Due to minimal marketing expenses (Closed End
Funds rarely advertise and don't pay distributors.) and typically lower
turnover, CEFs have lower operating costs than
traditional mutual funds. They trade like Common Stocks, with
the normal, variable, expenses that trading involves. [If
you are this deep into my website, you are probably aware of my feelings
that commissions and taxes are secondary issues that should not be
allowed to play a role in investment decision making. Don't allow the
Tail to Wag the Dog!]
CEFs do not impose annual 12b-1 fees, as most traditional mutual
funds do, BUT they probably do pay the fund manager too much money. Still,
if my Closed End Muni Bond fund is generating 6%+, payable in monthly
installments, I really don't care about the managers salary a whole lot!
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No Minimums - Because Closed End Funds trade on secondary markets
like other common stocks, there is no minimum purchase or sale
requirement. Investors may purchase or sell as little as they like. And
don't expect to receive a prospectus... yet another benefit since such
documents are written in a foreign language anyway.
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Distributions - CEFs make distributions
according to a prescribed schedule, which allows investors to plan the
timing of their cash flow. The actual amount of the
distributions may vary with fund performance, interest rates, and
general market conditions. A stable monthly cash flow is easier to
create with CEFs than with individual bonds, mortgages, and preferred stocks...and
significantly less risky. Many funds make
their "Capital Gains" Distributions early in the year
following the actual transactions. This may cause some inconvenience for
accountants, but think of the potential for income increasing management
strategies! [Remember, it's your
accountant's job to make you
happy...not vice versa.]
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Investment Risk - All true
investments involve similar types of risk. Closed End Funds
involve the same risks as common stocks: Prices Fluctuate; Management
Skills vary from company to company; Markets rise and fall; Interest
Rates change. The rules of Investing (Quality,
Diversification, and Income) and of Management (Planning, Organizing,
Controlling, Decision Making) always apply. CEFs
are not miracle drugs, just another means to the end of creating a more manageable, safer, and more productive
portfolio
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| The source of much of the information
above (and below) is: ETFConnect.com.
You should go there! |
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No matter how they are
packaged, Index Funds can never be much more than gaming devices and
hedging tools. For a complete discussion, go to ETFConnect.com. |
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he (many)
Disadvantages of Exchange
Traded Index Funds (ETFs)
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| Exchange Traded Index Funds
were created because they are easy to under explain and even easier to
over sell to those investors who are always looking for the short-cut to
portfolio growth. ETFs
are totally
different from CEFs, but by their very nature, can be a whole lot more exciting.
You are betting on the movement of a sector, an index, an economy: When
the index goes up, you make money on paper, but you have to pull the
trigger and sell to keep you winnings. Thus, you have to fight back the
greed... all of the time. And then there's the fear when the market
turns south, and you really have no clue about what you actually own..
Market timing has never worked long enough to make you rich, and all an
ETF is a market timing scam that has been turbo charged and well
marketed.
In general, one could observe that an ETF
"reports" the market, while a CEF "anticipates" the
market. I'm not sure which is more valuable, or accurate, but without going into any detail, here is a
list of the problems I have with ETFs:
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(1) They are passive, un-managed, investment
products, with no redeeming (investment) characteristics.
(2) They are designed to
facilitate general market timing and sector timing strategies of gurus
with the latest crystal ball prediction technologies.
(3) There are a
confusing number of varieties of ETF structures which promise
"insider trading" and manipulative privileges to the sponsors.
The number of new ETFs increases ever day... a clear indication of undue
speculation.
(4) The Market Price is
"supported" for ever, to keep it close to Net Asset Value, making this
class of funds particularly attractive to arbitrageurs.
(5) Buy 'n Holders are
assured of never having a chance to do as well as (forget better) than
the index itself...ever!
(6) Users lose the ability to use
an Asset Allocation Formula properly.
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Now
back to CEFs... not always a great investment!
Caveat Investor: Just
like any other investment, absolutely never purchase a CEF on the IPO...
too much hype, and the costs are indeterminable without close study of
the prospectus.
No, the investor
doesn't pay the commission on the IPO, but there is typically a
"selling charge" of about 4%, paid by the issuer. In addition, all the offering and filing expenses are subtracted from
the proceeds of the IPO...roughly 10% of the total capital raised, is
not handed over to the manager to put to work for YOU!
Additionally,
it is common practice for more shares to be sold than actually exist.
For the first few months after issue, the price of the new issue is supported
by the resultant short covering.
Typically,
after about 90 days, demand falls and so does the
price, as the market distills off the expenses and allows the real net
asset value to surface. The lesson is simple. CEFs are great investment
vehicles that need to be purchased old.
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