Closed-End Funds a Good Investment?

[ThriftyD]

Hi MMM friends.

Recently I have been looking into adding some new investments to my portfolio to supplement my various MMM-recommended Vanguard mutual funds as well as a handful of individual stocks.  I've been looking into some convertible closed-end funds as I'm attracted to the consistent and somewhat high yields.  Many of the funds I'm looking into pay monthly dividends and while they underlying price of the stock/fund doesn't fluctuate too much, the dividends remain consistent month after month. 

Specifically, I am looking into various funds in the Calamos family (Calamos Convertible Opportunities and Income Fund (CHI) and Calamos Convertible & High Income Fund (CHY).  Some of the PIMCO funds stick out to me too.  The Calmos funds pay between 8-10% dividends on an annualized basis and have consistently paid the same dividend amount each month since their inception. 

What are some of the drawbacks/risks to these funds?  Are the dividends taxed as ordinary income similar to REITs or do they have the favorable dividend tax rate?

At first blush I think these are great in that I could just reinvest those dividends each month instead of having to reinvest on a quarterly basis, allowing me to compound quicker.  But I'm also concerned that this may fall under the "too good to be true" category. 

Any advice on these CEFs would be appreciated!

Thanks all

[brewer12345]

EFs can indeed be a good investment - or they can be horrible.  Yield should always be a secondary or tertiary consideration because many CEF managers will pay out cash distributions even when they are liquidating principal to do so.  Other gotchas can include:

- Unlike open end mutual funds, CEFs can and frequently do use significant leverage.  This can make things even better or really bad.  Pay attention to the leverage in use at the funds you are considering.

- Some CEFs have ridiculous management fees.  I try to stay below 1% annually, but sometimes that means I pass on otherwise attractive funds.

- The crowd matters a lot more for CEFs than it doe for traditional mutual funds. I have seen numerous cases where a fund will be doing really well and the manager is kicking ass, but when the manager reduces the monthly payout the herd panics and sells.

A great resource is www.cefconnect.com  You can look up an individual fund, run screens, etc.  I usually use the following criteria:

- A fat discount to NAV.  At least 10% for a leveraged fund, north of 5% for a relatively plain vanilla unlevered fund.

- A good manager for the money.  They are good, bad and indifferent - pick good ones.

- Management fee under 1%.

- Ideally you also want to see a catalyst that might cause the discount to collapse.  ACG for example has been the target of some activism and may be in the future. Other funds will aggressively buy back shares at a big discount or boost payouts.  PEO has been making some moves in this direction.

Take a look at GIM.  It is a poster child for what I like (and I own it).  Reasonable fee, little or no leverage, very sharp managers with a long track record, a payout that largely tracks portfolio coupons (no cheating), and a history of returning to a premium after some time at a discount.

[AmericanEagle]

EFs can indeed be a good investment - or they can be horrible.  Yield should always be a secondary or tertiary consideration because many CEF managers will pay out cash distributions even when they are liquidating principal to do so.  Other gotchas can include:

- Unlike open end mutual funds, CEFs can and frequently do use significant leverage.  This can make things even better or really bad.  Pay attention to the leverage in use at the funds you are considering.

- Some CEFs have ridiculous management fees.  I try to stay below 1% annually, but sometimes that means I pass on otherwise attractive funds.

- The crowd matters a lot more for CEFs than it doe for traditional mutual funds. I have seen numerous cases where a fund will be doing really well and the manager is kicking ass, but when the manager reduces the monthly payout the herd panics and sells.

A great resource is www.cefconnect.com  You can look up an individual fund, run screens, etc.  I usually use the following criteria:

- A fat discount to NAV.  At least 10% for a leveraged fund, north of 5% for a relatively plain vanilla unlevered fund.

- A good manager for the money.  They are good, bad and indifferent - pick good ones.

- Management fee under 1%.

- Ideally you also want to see a catalyst that might cause the discount to collapse.  ACG for example has been the target of some activism and may be in the future. Other funds will aggressively buy back shares at a big discount or boost payouts.  PEO has been making some moves in this direction.

Take a look at GIM.  It is a poster child for what I like (and I own it).  Reasonable fee, little or no leverage, very sharp managers with a long track record, a payout that largely tracks portfolio coupons (no cheating), and a history of returning to a premium after some time at a discount.

Good post, thanks for the referral to the cef connect web site.  I hadn't known about that.  Personally I like Adams Express -- it's been around since 1929, has a good discount and consistent yield.

[kyleaaa]

If this is a long-term investment in a taxable account, high yields will inhibit compounding rather than help it because of taxes. Tax treatment of the dividends will vary depending on what the fund is invested in, but they are likely to be taxable at your regular tax rate rather than at the lower qualified dividends rate. Just depends. Even so, all else being equal, less yield is preferable to more yield in taxable accounts.

Risk and return are intertwined. If a fund offers a high dividend return, it says exactly what you'd think it would say about the risk of the fund.

[rmendpara]

Hi MMM friends.

Recently I have been looking into adding some new investments to my portfolio to supplement my various MMM-recommended Vanguard mutual funds as well as a handful of individual stocks.  I've been looking into some convertible closed-end funds as I'm attracted to the consistent and somewhat high yields.  Many of the funds I'm looking into pay monthly dividends and while they underlying price of the stock/fund doesn't fluctuate too much, the dividends remain consistent month after month. 

Specifically, I am looking into various funds in the Calamos family (Calamos Convertible Opportunities and Income Fund (CHI) and Calamos Convertible & High Income Fund (CHY).  Some of the PIMCO funds stick out to me too.  The Calmos funds pay between 8-10% dividends on an annualized basis and have consistently paid the same dividend amount each month since their inception. 

What are some of the drawbacks/risks to these funds?  Are the dividends taxed as ordinary income similar to REITs or do they have the favorable dividend tax rate?

At first blush I think these are great in that I could just reinvest those dividends each month instead of having to reinvest on a quarterly basis, allowing me to compound quicker.  But I'm also concerned that this may fall under the "too good to be true" category. 

Any advice on these CEFs would be appreciated!

Thanks all

Main point: When it comes to investing, there is no such thing as a free lunch!

If some investment offers a higher yield than another, there's a reason for it and you need to do your homework so you understand the unique risk/reward and how it may (or may not) help you reach your goals.

Personally, I own a lot of CEFs as I find it is a way to (generally) get exposure to some strategy that I could not replicate on my own.

Examples, DPO (covered call strategy on Dow index), QQQX (options strategy on Nasdaq index), and many, many others.

In general, distributions from these funds will be taxed as ordinary income... but this obviously depends on how the fund makes money. If it's a leveraged dividend fund, it may be (mostly) taxed at dividend tax rates. If it's some derivative strategy, then it will likely be taxed as ordinary income.

If you look at any of the long-standing CEFs, the ones that are intended to track an index seem to do a decent job of it. Usually they will underperform the benchmark index in the long term (not including distributions).

Personally, I hold quite a few CEFs (maybe ~20% of my total portfolio), but this will shrink over time as I'm not adding to new/existing holdings much and am pouring a lot into my 401k and IRA in more plain vanilla stuff.

If you can stomach the volatility, go for it, BUT realize you're paying for the yield with higher volatility.

NO FREE LUNCH. Repeat this to yourself whenever you start feeling piggish.

Bulls make money. Bears make money. Pigs get slaughtered.

Always understand the risk/reward before clicking "buy".

[ThriftyD]

Thank you all! 

Especially thanks to brewer12345 and endpara for your thorough insights.  I'm very inexperienced with CEFs and I wanted to get some input from fellow mustachians as I try to understand them better and certainly before I pull the trigger on any and add them to my portfolio.  I will take a closer look at GIM and Adams Express per the recommendations.  Thanks for the CEF Connect link too!