Solid Bond and Preferred Stock Portfolios in Liquid Form

A Closed End Fund (CEF) is a publicly traded investment company that invests in a variety of securities such as stocks, bonds, preferred stocks, loans, real estate, mortgages, oil and gas royalties, etc. The variety of sectors, classifications, and geographical representation is every bit as complete and varied as it is with Mutual Funds and ETFs, but CEFs boast significant advantages that are easy to understand.

NOTE: The first CEF came to market in 1893, roughly 30 years before the first Mutual Fund; four "depression era" funds are still in operation (GAM,TY, ADX, and CET). The first Exchange Traded Fund (ETF) was launched in 1993.

CEF capital is raised through an initial public offering (IPO) of common stock and the proceeds are invested according to the investment objectives of the fund. Like a traditional (open end) mutual fund, a Closed End Fund has a board of directors, appoints an investment advisor and employs a portfolio manager, but that's where the similarities end.

Mutual Funds have managers, but their management is impaired by mob sentiment. When the mob screams "sell", sell they must; when greed is in charge, they must continue to buy regardless of price. ETFs are unmanaged, and prices are manipulated by adding and removing shares from the marketplace. Both struggle to maintain parity between net asset value(NAV) and market price.

Unlike mutual funds, CEFs do not issue and redeem shares directly with investors at net asset value. CEFs are listed on national securities exchanges, where shares of the Investment Company are purchased and sold in transactions with other investors, just like individual company stocks, and most often not at net asset value. The whims of shareholders have no direct impact on the manager's decision making.

Brokerage firm statements will list these securities as equities or funds, totally out of sync with the purpose or nature of the securities contained within. If you have a portfolio full of municipal bond CEFs, the brokerage firm is allowed to tell you that you are 100% invested in equities!

Although the number of outstanding shares of a CEF remain relatively constant, additional shares can be created through secondary offerings, rights offerings, and/or the issuance of shares for dividend reinvestment.

Existing owners always get the first shot at new shares, in proportion to their holdings, so they can choose to protect themselves from any dilution of interest. Again, vastly different from traditional mutual funds, where dilution is their very nature.

Many of the advantages of Closed End Funds are discussed below. It should be abundantly clear that this form of investment fund has eliminated nearly all of the drawbacks of conventional mutual funds. The two have almost nothing in common.

Trading Liquidity - Flexibility - Cost: Closed End Fund shares may be bought or sold at any time during the trading day, just like common stocks, and share prices will fluctuate. They are excellent start up investment vehicles for smaller accounts where diversification would normally be difficult to achieve.

Those of you who have owned individual income securities (bonds, preferreds, mortgages, loans, real estate) know how difficult (and expensive) it is to move in or out of them. CEFs bring liquidity at no cost to this totally illiquid class of securities, making them as instantly tradable as common stocks.

There are no penalties for leaving the CEF when the stock is sold, as there can be in some mutual funds. The only direct cost involved is the commission (if any) paid when buying or selling the shares. Dividends paid are net of all fund expenses, and significantly higher than those paid by any other investment product.

Leverage IS an Advantage: Closed End Fund managements borrow money and issue Preferred Stock to raise money in addition to that produced by the IPO. The proceeds add more securities to the fund assets, thus increasing the income productivity of the investment portfolio, and the amount payable to shareholders.

IPO proceeds purchase investment securities; short term borrowing (leverage) adds to the portfolio; long term preferred share proceeds add to the portfolio, and long term borrowing helps pay the overhead... a fairly familiar business plan, right?

As long as the short-term interest rates paid to the lenders and the dividends paid to preferred shareholders are lower than the net interest and dividend rates earned by the portfolio, the CEF shareholders will receive much larger dividends than they would with just the IPO proceeds.

If you can borrow money at 1% short term, and invest it at 3% long term (rinse and repeat), how's your leverage doing?

Rising interest rates aren't nearly as scary as CEF critics would like you to believe. The manager can reduce the leverage (it's very short term, and interest rates rarely rise quickly), and doesn't it go without saying that higher rates on new investments are on their way?

Lower interest rates are even more of a problem than higher ones, for CEFs and all other forms of investment. How many millions of retiree and cd/bond/treasury investor dollars have been forced into the stock market (mostly into unmanaged ETFs and MFs) by historically low interest rates? The 12 year rally in the stock market was as much a function of low interest rates as it was great economic progress. Who can live on 1% of their nest egg?

Leverage is not a four letter word. All debt is a from of leverage and, without it, you would probably be peddling to work instead of driving that Mercedes.

Efficient Portfolio Management: Unlike open-end mutual funds, the asset base for CEFs is relatively stable. Without the pressure of constantly investing or redeeming securities based on investor demands, CEF managers are in charge of the fund and use their own experienced judgment to make investment decisions --- uninfluenced by the fear and greed of "the mob".

Fund Expenses: Due to minimal marketing expenses and typically lower turnover, CEFs have lower operating costs than traditional mutual funds. (Investment companies rarely advertise their CEFs and don't pay distributors.) They trade like common stocks, with the normal variable expenses that trading involves.

CEFs do not impose annual 12b-1 fees, as mutual funds do, BUT they do pay their fund managers generously. Still, if my Closed End Bond fund is generating 8%, in monthly installments, the manager is certainly earning it.

No Minimums: Because Closed End Funds trade on secondary markets like other common stocks, there is no minimum purchase or sale requirement. Investors may purchase or sell as little as they like. And don't expect to receive a prospectus --- yet another benefit since such documents are written in unintelligible legalese anyway.

Distributions: CEFs make distributions according to a prescribed schedule, which allows investors to plan the timing of their cash flow. The actual amount of the distributions may vary with fund performance, interest rates, and general market conditions.

Still, a stable monthly cash flow is easier to create with CEFs than with individual bonds, mortgages, and preferred stocks --- and they are significantly less risky, simply as a result of their significant diversification. How many individuals can own 300 different corporate bonds or preferred stocks, laddered properly, diversified properly, and watched over professionally?

As this is being written, many income and equity CEFs are generating dividends greater than 8% or 9% because their prices have fallen with the correction... during the financial crisis of 2007 -2008, these very same companies proved able to maintain their payments throughout the crisis.

Many CEFs make their capital gains distributions toward the end of the calendar year, so each year it is likely that some of your holdings might provide a year end bonus. As with equities, dividend levels are very reluctantly reduced, and are sometimes continued in spite of lower earnings. In such cases, the fund may return a portion of capital to investors to stabilize the cash flow.

So long as investors are aware of the Return of Capital (ROC), the increased cash flow can become an additional bonus for reinvestment to reduce cost basis and increase yield in other issues... while it automatically reduces cost basis of the issuing CEF. ROC only becomes "destructive" if the recipient does not reinvest it.

Investment Risk: All true investments involve similar types of risk. CEFs involve the same risks as common stocks: prices will fluctuate; management skills vary from company to company; markets rise and fall; interest rates change. But they avoid the mob sentiment fear and greed that have plagued the markets since self directed retirement money made mutual funds and ETFs so popular.

CEFs are not miracle drugs, just another means to the end of creating a more manageable, safer, and more productive portfolio. They are the income security of choice used within the Market Cycle Investment Management strategy and they are the only vehicle I know of that is able to produce a "retirement ready portfolio".

Retirement readiness is being able to say: "Neither a stock market correction nor rising interest rates will have a negative impact on the income produced by my investment portfolio. In fact, historically speaking, I have been able to grow my income even faster in either scenario".

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