How I Use CEFs for Income

It's like buying money on sale

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You’ve probably heard of mutual funds. Many of the investment choices offered through workplace retirement plans are mutual funds. These offer a way to own a diversified portfolio of individual stocks in a nice neat package. They are often actively managed and charge a fee for that management.

Mutual funds accept a constant flow of new investment capital, issue new shares, and buy back their own shares on demand. They are priced once a day at the close of trading, based on their net asset value (NAV)—the value of all the underlying holdings if you were to sell them off at that point in time.

Many people have never heard of CEFs, or closed-end funds. CEFs are similar to mutual funds. But they differ in several important ways.

CEFs sell a set number of shares once through an initial public offering (IPO) to raise investment capital. These shares are then traded on a stock exchange, with no new shares being issued or new money added to the fund. This means that their price can fluctuate based on supply and demand. So CEFs typically trade at a premium or discount to their NAV due to market conditions, thus offering opportunities for investors.

Another difference is the need for cash reserves. Mutual fund managers need to maintain cash reserves to meet potential shareholder redemptions in a falling market or put new money to work in rising markets. CEF fund managers do not. CEFs trade in the secondary market on an exchange, and investors who wish to buy or sell their shares do so via the exchange at the market price, not through the fund sponsor. Thus, CEF managers can remain focused on the fund’s investment strategy because no cash is flowing into or out of the portfolio. So, they can run more stable, fully invested portfolios, potentially resulting in higher net yields.

What I like about CEFs

Buying shares of a CEF when it is trading at a discount to its NAV really is like buying income (money) on sale. Let’s say that the NAV of fund XYZ is $20 per share. But it’s selling on the open market at $18.80, a 6% discount. It also yields an annual distribution of $1.316, paid monthly, or $.1096 per share per month. This means that I can buy $20’s worth of assets for $18.80 and get paid just under $.11 per share every month to hold on to it. What’s not to like? This is why CEFs are popular with retirees and people like me who want income now.

How I use CEFs in my total portfolio

As mentioned previously, I tend to have more individual dividend payers and ETFs in the taxable account. I also have some tax-advantaged CEFs that produce about 15% of the total portfolio income in my taxable account. These include several Eaton Vance funds and a municipal bond fund (Nuveen) that is tax-free.

The rest of my CEFs are in tax-advantaged accounts, especially the Roths. Re-investing the distributions here in these accounts via DRIP lowers my cost basis and builds some margin of safety if I ever want to sell. I do rotate out of one fund and into another sometimes, especially if one fund is trading at a premium and I can get a similar fund at a discount instead. For example, over the past year, I’ve trimmed some of my PDI shares and bought PDO and PDX instead.

I like CEFs as a way to get exposure to sectors of the markets where I’m not comfortable choosing individual stocks or where the dividends are low or nonexistent—a lot of the tech stocks, for example. I don’t mind paying the fee for a fund that is professionally managed by someone who knows more than I do about that area. I’m still getting paid a pretty fat distribution.

Keep in mind that most CEFs are designed to produce steady income rather than big capital gains. In terms of overall portfolio construction, I try to keep CEFs at under 40% of the portfolio, which some might consider risky. I use CEFs, along with BDCs and REITs to boost my total income. I also hold some growth stocks, like MSFT, along with dividend aristocrats like KO, JNJ, and GD.

What to look for in a CEF

Over time, price tends to catch up with NAV, so it’s important to buy CEFs when they are trading at their NAV or at a discount, if you want to aim for a capital gain as well as getting regular income. Also look for CEFs that have a history of maintaining or