Should You Buy High-Yield Closed-End Funds?

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- At a time when money-market funds yield almost nothing, some closed-end funds offer an intriguing option for income-oriented investors.

The closed-ends aim to pay fixed annual yields. In a typical arrangement, a fund announces its intention to pay out 5% or more of its assets annually. Investors can spend the cash payments or reinvest the money.

The Closed-End Fund Association tracks 36 funds with managed distribution policies. Funds on the list include Gabelli Equity ( GAB), which seeks to pay out at least 10% of its assets annually, and Royce Micro-Cap Trust ( RMT), which pays out 5%. Other funds that have distributed more than 5% include Cohen & Steers Dividend Majors ( DVM), H&Q Healthcare Investors ( HQH), and John Hancock Bank & Thrift ( BTO).

Should you buy funds with fat managed distributions? Perhaps. For retirees and other income-oriented investors, the funds offer a steady source of cash that can be used to cover bills. But the funds can be hazardous. When distributions are too steep, they can quickly erode long-term returns.

Like conventional mutual funds, closed-end funds hold portfolios of stocks or bonds. In an ideal situation, the portfolio holdings generate dividend income and capital gains, which can be distributed to shareholders.

Say a fund has a 6% managed distribution. During a bull market, the fund can easily cover the distribution by paying out capital gains and income. But if the fund suffers big losses in a market downturn, then there might not be enough income and capital gains to cover the distribution. In that case, the portfolio manager would be forced to liquidate fund assets in order to obtain cash for the distribution. This is known as a return of capital, and shareholders should not welcome it, says John Cole Scott, a portfolio manager with Closed-End Advisors, an investment advisor. "It makes no sense to own a fund that is just going to return your own money to you," he says.

Scott says some investors buy funds with big distributions and don't understand that much of the cash represents a return of capital. "If you see a fund with a 13% distribution, then you have to wonder where the money is coming from," he says.

A fund that habitually returns capital to shareholders is Cornerstone Total Return ( CRF). Last year, the fund distributed about 16% of assets, including return of capital.

A fund that Scott likes is Adams Express ( ADX), which recently instituted a managed distribution of 6%. Scott says that Adams Express has a record of generating income and capital gains. If that continues, the fund will be able to maintain its distribution without resorting to returns of capital.

Besides providing steady cash payouts, managed distributions can also boost the value of fund shares, says Scott. This can occur because of the peculiar structure of the funds. Closed-end funds issue a fixed numbers of shares that trade on stock exchanges. When a fund is out of favor with investors, the shares can sink and sell for a discount to the value of the assets in the portfolio. Say a fund sells at a 10% discount. Shareholders may be frustrated because they can only sell their holdings for 90% of the value of the portfolio assets. By offering managed distributions, funds hope to attract more investors. That may boost share prices and reduce discounts.

Adams Express, which has $1 billion in assets, introduced its distribution because the fund hopes to eliminate a persistent discount. One of the oldest funds, Adams was founded in 1929 and has long focused on buying blue-chip stocks. The goal has been to outdo the S&P 500 slightly while taking less risk. During the past 10 years, the fund's portfolio holdings have achieved the target.

The net asset value of the portfolio has gained 2.7% annually, edging out the benchmark, according to Morningstar. But shareholders haven't necessarily gotten the full benefit of the good returns. The problem is that a decade ago, the shares sold for a discount of around 10%. Since then the fund has fallen out of favor, and the shares dropped to a discount of around 16%.

Angry at the discount, an activist shareholder proposed liquidating the fund. If that happened, the fund would have gone out of existence, and shareholders would receive 100 cents for each dollar of assets. Most shareholders recently voted against liquidating. But the fund management decided to offer a 6% managed distribution, hoping to boost the share price and quell dissent.

Will the new distribution by Adams Express help boost the share price? Probably, says John Cole Scott. "Over time the discount could hit 14%, and that will help shareholders," he says.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

More from Mutual Funds

How to Outperform a Mutual Fund

How to Outperform a Mutual Fund

Retirees Make One Big Investing Mistake - Not Planning!

Retirees Make One Big Investing Mistake - Not Planning!

What the Coming S&P Sector Changes Mean for Investors

What the Coming S&P Sector Changes Mean for Investors

ETFs vs. Mutual Funds: Which Should You Choose?

ETFs vs. Mutual Funds: Which Should You Choose?

60 Seconds: How to Survive a Market Meltdown

60 Seconds: How to Survive a Market Meltdown