Closed-end funds (CEFs) are unique investment vehicles with plenty of quirks that scare many investors away. Those willing to do their homework, however, will find a relatively untapped pocket of the market with potential opportunities to exploit.

CEFs account for a small portion of the managed fund universe-according to Morningstar, approximately $435 billion in total assets across 520 funds as of the end of May compared with over $3.5 trillion across more than two thousand exchange-traded funds (ETFs), and $11 trillion across tens of thousands of traditional mutual funds. This discrepancy in size and number of products is a key reason why CEFs are often ignored by investors, though complexity remains a huge hurdle.

There are several important differences between a CEF and a traditional mutual fund or ETF, both of which must be entirely understood before investors consider making a move.

First, and most importantly, all CEFs have a closed capital base (meaning the fund does not create new shares when investors buy shares). Instead, CEF investors buy and sell shares amongst themselves. This gives rise to two "prices" for CEFs-a net asset value (NAV) and a share price. The NAV, just like a traditional mutual fund or ETF, is simply the sum of the market value of all the underlying holdings, while the share price fluctuates throughout the day based on supply and demand. Because the share price can (and typically does) differ from the NAV, shares of CEFs can often be purchased at either a discount (share price is less than NAV) or a premium (share price is greater than NAV).

More on this later.

The use of leverage is the next difference between CEFs and traditional mutual funds, with a majority of CEFs utilizing this feature.

Leverage can be created in various ways, but the result is the same-a CEF borrows money (either by issuing debt or preferred stock) and pays interest or dividends to the bond and stock holders. That money is then invested, creating leveraged exposure to the fund's investment process and philosophy. This can be a complicated topic, but the most important things to know are that leverage is not free and those costs are borne by shareholders, and leverage increases the volatility of returns. Leverage can be (and sometimes is) used in traditional mutual funds or ETFs, but its prevalence is much lower.

Finally, distributions paid by CEFs may differ from those paid by traditional mutual funds or ETFs.

Distributions tend to be higher-mostly due to the leverage discussed above, but can also be due to more aggressive strategies that are more easily employed inside the closed capital base-but the makeup of the distributions can vary as well. CEFs typically pay distributions throughout the year, often monthly or quarterly. To do so, they must receive special permission to pay capital gains to shareholders more than once per year. A traditional mutual fund is limited to a once-per-year distribution of capital gains and most pay those out towards the end of the calendar year. A CEF's regular distribution payment may consist of income (from dividends or bond coupons), capital gains (from both stocks and bonds), and return of capital.

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Return of capital is, at its worst, the fund returning investors' own cash to them disguised as a distribution payment, or, at its most innocuous, a tax-delaying tactic which reduces the cost basis of the investment.

Most investors are attracted to CEFs for two reasons: the typically large distribution payments and the discount at which investors can buy them.

As discussed earlier, a CEF has both a NAV and a share price and the difference between the two is the discount. If a fund's share price is lower than its NAV, which is often the case, the fund is said to trade at a discount. If the share price is higher, it trades at a premium. It's important to remember, however, that a fund's discount or premium is simply the relationship between the share price and NAV. Just because a CEF trades at a discount does not mean it is "cheap." Most CEFs trade at discounts and many never trade at a premium or even at par (where share price equals NAV). To gauge whether a CEF's discount or premium is cheap (yes, a CEF selling at a premium can be cheap), investors need to look at relative discounts and premiums-relative to its similarly invested peers and to its own historical trading pattern.

If a fund is selling at a discount or premium that is well below its peers or its own historical averages, it could be an indication that the fund is undervalued. It could also be an indication that something is going wrong with the fund-a manager or strategy shift, a recent distribution cut, poor performance, or any number of other issues. Additional analysis is always required.

Finding truly undervalued CEFs can offer several advantages.

Certainly, should the discount or premium revert to its more normal levels, the investor may realize a gain. But, if an investor considers the distribution an important part of the CEF's total return stream, buying discounted shares also increases the "yield" earned by the investor. For example, take a fund that pays a $0.10/month distribution, with a NAV of $10 and share price of $9. The fund's distribution rate based on the NAV is 12% while the distribution rate based on the share price is 13%-that's a healthy yield enhancement due to the discounted price.

Investing in a CEF is no different from investing in a stock, mutual fund, or ETF, but the unique structure does require additional research and understating. Looking simply at a CEF's discount or distribution rate is not prudent. Investors must understand the investment process and philosophy, the team managing the assets, historical trading patterns (to gain insight into current valuations), and the makeup of the distribution stream in order to make a fully informed investment decision.

By: Cara Esser, CFA

Cara Esser is a senior investment research analyst and investment committee member in Mesirow Financial's Retirement Planning and Advisory group.