We want our clients to understand the features, options and risks of each investment vehicle they consider. This disclosure explains certain options and features which are common to most CEFs. Of course, we cannot cover everything about CEFs. The best source of information about a specific CEF is the investor prospectus prepared by the fund manager, which your Janney Financial Advisor can provide upon request. If you have questions about an investment, you should discuss them with your Financial Advisor before you invest.
What is a CEF?
CEFs are similar to mutual funds in that investors pool money together to purchase a professionally managed portfolio of securities. Unlike mutual funds, that continuously offer and redeem their shares on a daily basis at net asset value (NAV), CEFs initially raise money by selling a fixed number of shares of common stock in a single one-time offering after which the shares are traded on an exchange at a price set by the forces of demand and supply. Therefore, a CEF has both a NAV and a price, and these two values may differ. Changes in investor demand for a particular CEF may cause the fund to trade at a price that is greater (premium) or lower (discount) than the fund’s NAV. Since a CEF’s premium and discount to its NAV may narrow or widen, the fund’s price return may differ from its NAV return.
One of the most distinctive characteristics of CEFs is the ability to use leverage. Many CEFs use leverage to try to improve the yield and overall performance of their funds. This is accomplished by borrowing at a low rate and investing the borrowed funds at an anticipated higher rate. The difference between the fund's interest earnings and leverage costs is called the spread, which is usually paid to investors, and therefore increases yield.
Most CEFs are structured as perpetual funds having no maturity date; however, there are two CEF structures known as term funds and target-term funds that mature at a certain point in time. Term Funds mature on a specific date and will liquidate and distribute the fund’s closing NAV to shareholders at maturity. Target-Term Funds also mature on a specific date with the added benefit of returning shareholders a specific, predetermined NAV per share, which is usually the original NAV when the fund is created.
There are different types of CEFs that invest in equity securities such as large-cap, mid-cap, and small-cap stocks, growth stocks, value stocks, dividend-producing stocks, foreign stocks, preferred stocks, convertible securities, stocks of companies in a particular industry or sector, and stocks of companies in a particular country or region. CEFs also invest in fixed income securities, such as corporate bonds, US Government and agency securities, mortgage-backed and asset-backed securities, collateralized mortgage and collateralized debt obligations, short-term instruments, loan participation interests, high-yield debt, emerging market debt, municipal bonds, state-specific bonds, and taxable municipal bonds.
Internal Costs of Investing in CEFs
CEF managers assess fees for the operation and management of the fund. The fund pays expenses directly from the fund’s assets. Typically, CEF expenses consist of management fees, shareholder servicing agent expenses, interest expense, custodian’s fees, directors/trustee fees, professional fees, shareholder reporting expenses, stock listing fees, investor relations expenses, and other miscellaneous expenses. Expenses may have a tangible effect on the overall total return profile for a fund. It is with this in mind that investors should closely monitor the fund’s cost of ownership in light of the management’s expertise and performance.
Risks of Investing in CEFs
Investing in any CEF involves risk, including, but not limited to, market risk, issuer risk, credit risk, interest rate risk, income risk, prepayment risk, inflation risk, liquidity risk, political risk, and currency risk. Additionally, municipal funds may experience state-specific risk and credit risk.
While leveraged CEFs often offer higher yields than their non-leveraged or open-ended counterparts, leverage can significantly increase both overall risk and volatility. Such leverage may present the opportunity to enhance potential returns but also involves the risk of exacerbating losses and depreciation in the value of the underlying securities.
Before investing, carefully consider all risks and read the prospectus for the specific fund which is available on the investment company website.
Investing in a CEF IPOs
CEF Initial Public Offerings or IPOs carry a few specific risks. The assets raised are invested according to the fund's strategy and distribution to shareholders do not typically occur until 60-90 days after the initial public offering (IPO). Because the fund does not exist until after the IPO there are no historical performance figures. A fund manager’s success with other funds does not guarantee the CEF’s successful execution or future performance. Even with a sound strategy, timing plays a role in the CEF’s success and can impact returns.
Historically the fees associated with the IPO have been absorbed by the investor, often lowering the initial NAV by the offering expenses immediately. More recently, the fee structure has changed and fund issuers have absorbed the offerings expenses. Thus, the initial NAV has been equal to the public offering price.
CEFs should be part of a strategy that considers a wide variety of variables including the expected return on the asset class and the ability of the manager to utilize all of the structural benefits of the CEF vehicle such as leverage use, potentially illiquid securities, and maintenance of the investment strategy.
Understanding How Janney and Your Financial Advisor Are Compensated
Janney and our Financial Advisors receive compensation when clients purchase or sell a CEF. CEF Initial Public Offering fees are absorbed by the mutual fund sponsor. Costs associated with investing in existing CEFs result in transaction-based commission or an advisory fee which is a percentage of assets under management.
Through our relationship with CEF managers, Janney and our Financial Advisors may also receive other forms of compensation that do not directly affect the amounts our clients are charged, such as promotional assistance. These forms of compensation are meant to cover a variety of initiatives and expenses incurred by Janney, including expenses associated with marketing CEFs to investors, educating Financial Advisors, and performing administrative services for clients.
Janney Financial Advisors, consistent with the firm’s practices, may also receive non-cash compensation and other benefits from CEFs. Such non-cash compensation may include invitations to attend conferences or educational seminars sponsored by CEF mangers or their advisers or distributors, payment of related travel, lodging and meal expenses, and receipt of gifts and entertainment. Acceptance of these benefits is in accordance with industry regulations and Janney’s policies. Clients should review all CEF prospectuses and other offering documents for further explanation.
Receiving non-cash compensation presents a conflict of interest and gives Janney and its Financial Advisors an incentive to recommend investment products based on the compensation received, rather than based on a client’s needs. We address this conflict by maintaining policies limiting gifts and gratuities and disclosing this conflict to clients.