Funds for the Closed-Minded - TheStreet

Editor's note: This is the first in a series of articles that will look at "alternative" funds. We'll use the term alternative fairly broadly. Essentially, none of these investments should be part of the core holdings of any portfolio. Indeed, many of them are too gimmicky to even warrant a small percentage. But because the marketing machines at financial institutions continue to tout a variety of atypical investments, we'll examine them in detail.

A raft of closed-end fund offerings has hit the market recently, largely aimed at investors looking for a back door to big gains.

The strategy and management behind these closed-end funds -- such as CIBC's Advantage Advisers Multi-Sector Fund launched in April and Nuveen's Quality Preferred Income fund, with a launch planned for June -- can't be found in their mutual fund counterparts.

Then again, that's not necessarily a bad thing.

Closed-end funds shouldn't be core holdings. In fact, because of the way they're structured and traded, they're better suited for investors looking for supporting players in market niches.

But first, here are the basics.

Like mutual funds, closed-end funds are a type of investment company, registered with the

Securities and Exchange Commission

and subject to the same disclosure rules laid out in the Investment Company Act of 1940. And just like mutual funds, closed-end funds are structured to offer a variety of investment objectives, strategies and portfolios, some of which this column will look at more specifically in the future.

But that's where the similarities end.

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Closed-end funds (CEFs) trade on an exchange much the way individual stocks do. Generally, CEFs don't continuously offer their shares for sale as a mutual fund would. Rather, they sell a fixed number of shares at one time (in the initial public offering), after which the shares typically trade on a secondary market, such as the

New York Stock Exchange

or the

Nasdaq

.

After the fund's IPO, the market determines its share price. Just as a stock's price is often determined by fickle investor behavior, the shares of a CEF often trade at a discount or premium to its net asset value. (As you may know from mutual fund investing, the NAV is a fund's total assets minus its total liabilities. Mutual funds are required to disclose their NAVs daily; closed-end funds are not required to, although many do anyway.)

Since closed-end funds are traded much the way stocks are, shares must be bought through a broker -- either a discount broker such as Charles Schwab or a full-service firm. Again, as with stocks, it's almost never a good idea to buy a closed-end fund during its IPO. An underwriting charge is included in the initial price, which can be as much as 7%, according to Morningstar. And since shares of a CEF aren't likely to spike immediately after the IPO, there's nothing to lose by waiting.

"The biggest risk is the same as with investing in stock -- that you'll pay too much for your shares," says George Cole Scott, president and portfolio manager with Closed-End Fund Advisers. "But, if you buy at a discount, you can really do well."

Indeed, the idea of buying a fund at a discount to its NAV is one of the chief appeals of closed-end funds. Most funds trade at a discount -- 15% to 20% is not uncommon -- although academics and managers are at a loss for a definitive explanation as to why. That might seem great when you're buying into a fund, but could work against you as you're trying to unload your shares.

The discount factor makes closed-end funds particularly attractive to bond investors. Funds pay out income based on the net asset value -- regardless of what the fund shares are trading at. That's one reason why a closed-end bond fund often pays a higher yield than a comparable mutual fund, according to Russ Kinnell, an analyst with Morningstar.

Volatility

Another reason is that many closed-end bond funds use leverage, which boosts their income. Closed-end funds in general are often highly leveraged, unlike most traditional mutual funds. When the investment adviser for a CEF is feeling particularly bullish, for example, he or she can borrow additional funds to invest, enabling the fund to reap gains on borrowed money.

Such a strategy also makes these funds more volatile. Leveraged funds are great when interest rates are falling, but you don't want to be in one when interest rates rise.

The structure of closed-end funds makes them particularly well suited for illiquid investments. Closed-end fund shares are generally not redeemable. In other words, unlike mutual funds, CEFs are not required to buy shares back from investors upon request. Some closed-end funds, commonly referred to as interval funds, offer to repurchase their shares at specified intervals. "The fact that there are no issues with inflows and outflows can be a big positive," Kinnell says. "Especially for funds that invest in illiquid securities."

Closed-end funds are permitted to invest in a greater amount of "illiquid" securities than mutual funds. (An "illiquid" security, as defined by the SEC, is one that can't be sold within seven days at the approximate price used by the fund in determining NAV.) That's why you'll see many closed-end funds that invest in countries with restrictions on foreign investment (such as Korea), or in areas of the market that are naturally illiquid (such as private placements), or using hedging strategies that would be hurt by excessive inflows and outflows.

But if any of those fund styles appeal to you, consider that the less autonomy the individual investor has, the less responsive the fund manager needs to be. "Closed-end funds are generally not very shareholder friendly," Kinnell says. "Flows can be a problem for a fund, but they also serve as a good incentive for managers to do well and provide regular and transparent information."