Love Income: Try Closed-End Funds

I think that closed-end funds are my favorite products on the stock market. They aren’t very sexy, and they don’t give me sky-rocketing capital gains, but boy, do they get the job done.

And what job is that? Their job is to give me large amounts of income. I use closed-end funds as the anchor of my dividend portfolio, ensuring that I receive a nice piece of consistent income each and every month. But what are closed-end funds?

Closed-end funds are mutual funds that have a set amount of shares. The amount is set at the funds IPO and can only be changed by a management decision. This differs from open-end (normal) mutual funds and electronic traded funds (ETFs) because they buy more shares as more money comes into the funds.

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How does this mechanic change the buying thesis of these funds? Because the funds have a set amount of shares, they have a Net Asset Value or NAV. The NAV is the amount of the assets the fund holds, which differs from the price. Because of this, the funds can trade at a premium or a discount to NAV.

I will give you an example of NAV. Let’s take Pokemon cards, for example. For high-value cards, people can rate the card by sending it to a card specialist. Then, there is a book that tells the value of the card. Let’s say the book says the card is worth $5,000. When the card owner puts the card on the market, depending on the supply and demand, he could ask for more or less compared to the $5,000. The NAV is $5,000—the price is what the market will support.

Luckily, most brokerage firms and websites like Yahoo Finance display the NAV and the premium or discount for everyone to see easily. Here is an example from a PIMCO fund.

It is important to note that some funds may trade at a premium to NAV most of the time. This is because the fund manager is considered good, and the fund performs well. You pay more for quality funds. Yes, closed-end funds are actively managed.

One of the main selling points of ETFs, especially index funds, is that they are passively managed. Passively managed funds track a particular index and stick to that index. The robots can manage these funds; thus, the funds have a very low expense ratio. Sometimes the expense ratio is as low as 0.03%. 

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Actively managed funds have managers that have to be paid, making their expense ratios considerably higher than index funds. Some of my favorite funds have an expense ratio over 2%, which is an enormous leap over 0.03%.

The good part is that the dividend yield already subtracts the expense ratio. So if you see a dividend yield of 7%, that is after the expense ratio and the cost of leverage. Josh, what is leverage, and why do closed-end funds use it?

Leverage is the act of borrowing money and other such tactics to maximize returns. Inherently, borrowing money leads to interest costs, which are factored in before seeing the dividend yield. Leverage has another downside, though, and that has to do with interest rates.

Closed-end funds are notorious for performing poorly with changing interest rates and inflation. Using leverage can multiply your returns or compound your losses; this is just something to be aware of. Various CEFs perform differently in rising inflation and low/high-interest rate environments. You have to understand which CEFs you are investing in and why. 

Why Do I Need to Invest in the Stock Market?

Now, to the main attraction, the income—the main reason to buy CEFs is the monthly income. CEFs aren’t known to give high amounts of capital gains; however, if you follow a particular CEF, you will be able to buy it when it is on discount. 

The strategy I use is to follow 4-6 CEFs closely as my main income generators. Over the years, there will be great buying opportunities, and that is when you pounce. Just like I wrote in the Preferred Shares series, buying at a discount can genuinely maximize your returns. 

Most of the returns you will receive from CEFs will come in the form of dividends. So, if I buy a CEFs for $20/share, I expect it to stay somewhere between $20-23 for most of the time. If I can find it at a discount for, say, $15, then I can lock in some significant gains as well. Let’s look at my two favorite funds, PIMCO Dynamic Income (PCI) and Nuveen Tax-Free Municipal Bonds (NVG).

I have minimal capital gains but look at the estimated annual income. It is important to note that NVG has a lower dividend yield, but the entire dividend is tax-free because they invest in municipal bonds. So how does this income look on payday? Let’s take a look.

There are very few things as attractive as seeing these two dividends arrive on payday, each and every month. That is $60 coming that you can do anything you want with. That is enough to pay for Netflix, Hulu, and HBO MAX. 

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My goal with these CEFs is to get to a point where I can pay all of my bills just from them. But again, they should only be a portion of your income portfolio. I wish I could buy only CEFs for my dividend portfolio, but that would lead to trouble very quickly.

You see, the CEFs are not a massive part of my Wells Fargo portfolio. And across my entire portfolio, they are even smaller. I use the other dividend-payers to make up because my CEFs generally stay static on growth.

So I can buy other index funds, ETFs, and blue-chip dividend payers to protect my CEFs from themselves. Over the years, I will keep adding to my CEFs and eventually get them to pay me $2,000-$3,000 a month while still keeping them to 20% or less of my portfolio. That is a tall order, but in time I can achieve this. 

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That is the best way to employ CEFs, as an anchor to your portfolio. They can give you great consistent dividends. Stack some blue chips and index funds, and you have growth and income funds that protect you from inflation and pay you today. It is not a bad way to do business. 

Before you buy a CEF, look into the premium or discount to NAV, and read if it is historically a good time to buy. You can track the NAV to price over time. You may learn that certain funds can trade above NAV for years on end. 

Also, understand that they are leveraged funds and can be risky if you don’t know how they react to low/high-interest rates or inflation. Understand what sector and what the funds invest in. Some are real estate, banking, mortgage debt, infrastructure, etc. These are all things you should know before you spend your hard-earned dollars.

I love CEFs, and they have been very good to me over the last few years. If I were closer to retirement age, I would load up on CEFs for immediate income. I would also add in some preferred shares and dividend ETFs. I would also ensure I had 6-12 months’ pay in treasury bonds and cash in case of a market downturn. I wouldn’t want to sell CEFs when they are at their low points. I would like to be buying them at that time. 

Closed-End Funds are great if you understand what you are getting. Instead of getting the stock market 7-9% return in growth, you get it in pure income. There are trade-offs, but if you can leverage them correctly, they are a great addition to anyone investing for income. I know that I am an income investor, how about you? 

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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.  I have no business relationship with any company whose stock is mentioned in this article.