NEW YORK ( TheStreet ) -- Since the financial crisis, most mutual funds have delivered solid returns. But investors could have done even better with closed-end funds. During the three years ending in 2012, the average intermediate-term bond mutual fund returned 7.0% annually, compared to a return of 11.4% for closed-end peers, according to a Morningstar study. While emerging-markets mutual funds returned 4.3% annually, closed-end returned 6.7%. Most closed-end funds also topped comparable ETFs. The average foreign large value closed-end returned 5.7%, compared to 3.2% for comparable ETFs.
Morningstar analyst Mike Taggart says that the peculiar structure of closed-end funds has enabled them to get a big boost from the low interest rates of recent years. Like mutual funds, closed-end funds hold portfolios of stocks or bonds. But closed-end funds issue a limited number of shares that trade on stock exchanges. In contrast, traditional mutual funds can sell an unlimited number of shares.
Closed-end funds have gained an important edge because they can use leverage. In a typical deal, a fund starts by raising cash from investors. After investing the money in bonds or stocks, the closed-end portfolio manager can then borrow against the assets, taking a bank loan or issuing preferred shares. Using the proceeds of the borrowing, the manager buys more bonds or stocks. Many closed-end funds have leverage ratios of around 30%. So a fund that raised $100 million from investors would use borrowings to buy an additional $30 million in assets.
In the current low-rate environment, leverage is extremely profitable. A portfolio manager can pay 1% for a short-term loan -- and then use the cash to buy bonds that yield 4%. The extra income from the leveraged purchases boosts the fund's yield and total return. Regulators limit the ability of mutual funds to use leverage.
Make no mistake, leverage can be risky. Just as it can magnify gains in a bull market, leverage can exaggerate losses in a downturn. If interest rates spike, then closed-end bond funds could crater. Even in flat markets, leverage can make funds volatile.
Select the service that is right for you!COMPARE ALL SERVICES
Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV