Closed-end funds (CEFs) might not have the same name recognition as mutual funds and exchange-traded funds, but they have been staples in income portfolios for decades. They can be held in virtually any brokerage account or IRA, often sport very attractive yields, and, if timed well, they can also generate solid trading returns.
And if you can think of an asset class, chances are good there is a CEF trading it. Closed-end funds can hold stocks, corporate bonds, tax-free municipal bonds and virtually every other asset under the sun, including illiquid assets that are hard to own within a traditional mutual fund.
But what exactly is a closed-end fund, and how do you know what constitutes a good one? Today, we’re going to break down this market niche, then we’ll present you with seven of the best CEFs for 2023.
Disclaimer: This article does not constitute individualized investment advice. These funds appear for your consideration and not as investment recommendations. Act at your own discretion.
What Is a Closed-End Fund?
A closed-end fund is a special type of fund that shares certain things in common with their cousins: traditional open-end mutual funds and exchange-traded funds (ETFs).
But there are also critical differences that make CEFs very different from both.
CEFs vs. mutual funds vs. ETFs
CEFs are best understood by comparing them to the competition.
You’re likely very familiar with open-end mutual funds, which are the investment vehicle of choice for 401(k)s and other retirement plans. But you may not actually understand how they work.
When you invest in an open end mutual fund, you (or your broker) actually sends cash to the fund, which the manager then uses to buy stocks, bonds or other securities. And when you redeem, the mutual fund manager will send you or your broker the cash, even selling securities to free it up if need be.
Exchange-traded funds are different. Investors can buy or sell ETFs exactly as they would any stock. They trade on major stock exchanges.
Unlike mutual funds, you don’t actually send the manager money. New ETF shares can be created or destroyed by institutional investors based on market demand. (When shares are created, an institutional investor will essentially buy up the shares of stocks and bonds owned by the ETF, then trade them to the fund for shares of the ETF itself. When shares are destroyed, the institutional investor receives the underlying holdings.)
This creation and destruction of new ETF shares ensures that the ETF’s market price never deviates too far from the net asset value (NAV), or the value of the underlying holds.
And this brings us to CEFs.
Like open-end mutual funds and exchange-traded funds, closed-end funds are pooled investment vehicles. You have many investors pooling their assets into a common fund, which is invested by a manager or a team of managers. (And while mutual funds and ETFs can be index funds, which are rules-based and effectively run by computers, all CEFs are actively managed.)
Unlike mutual funds—but like exchange-traded funds—closed-end funds trade on a stock exchange. You buy the shares in a brokerage account and never send the manager cash.
Because ETFs and CEFs don’t have to meet redemptions like open-end mutual funds, liquidity is less of an issue. They can hold thinly traded or illiquid securities without having to worry about selling them due to a wave of redemptions.
But unlike exchange-traded funds, closed-end funds have no creation or destruction of shares. A CEF actually holds an initial public offering (IPO) when it creates its shares, and that number of shares is fixed. That might sound like a mundane detail, but it’s actually one of the most important aspects of CEFs. Here’s why:
Net asset value
Net asset value is the value of a fund’s net asset position (the value of the stocks, bonds, and other securities it owns minus any liabilities) divided by the number of shares outstanding.
Open-end mutual funds are always valued at their net asset value. And with exchange-traded funds, the shares’ net asset value will never deviate too much from the market price due to the creation and destruction mechanism. But because CEFs have no such mechanism, the market price of the shares can vary wildly from the net asset value. They can trade at large premiums to net assets or—benefiting us—at deep discounts.
Many closed-end fund investors prefer to buy CEFs when they are trading at deep discounts to net asset value. Why not? It’s intuitively appealing to buy that proverbial dollar for 95 cents.
Leverage is finance-speak for borrowing money to invest. This can boost returns, but it also increases risk. If you own a home, you know how this works. An increase or decrease in property value has an outsized impact on your home equity.
Closed-end funds will generally employ at least a modest amount of leverage, though it is not uncommon for a CEF to be leveraged as much as 30% to 40%. Of course, CEFs generally don’t “borrow on margin” like regular mom-and-pop investors. They generally have access to more sophisticated—and cheaper—funding options.
This leverage is a major reason that CEFs are able to generate some of the highest yields in the entire stock market. But it comes with risks. The same leverage that boosts returns when assets are rising compounds the losses when assets are falling. Furthermore, many CEFs tend to borrow at (normally) cheaper short-term rates and invest the proceeds in longer-term assets. That strategy is most profitable when the yield curve is steep (long-term rates are much higher than short-term rates), but it can be difficult to navigate when the yield curve is inverted (when short-term rates are higher than long-term rates).
When evaluating closed-end funds, you will want to take the leverage into consideration.
The majority of closed-end funds are income funds. Whether they are fixed-income closed-end funds (bonds) or equity closed-end funds (stocks), chances are good that income is a major investment objective, and CEFs tend to offer high yields.
CEFs generally do not pay taxes at the fund level so long as they distribute 90% or more of their dividend and interest income, and 98% of their realized capital gains. This tax incentive is another factor in the outsized payouts we see in this space.
Closed-end funds’ payouts are referred to as distributions. CEF distributions will generally come from some combination of four sources:
- Interest on fixed income or other interest-bearing securities
- Dividends from stocks
- Realized capital gains
- Return of capital
That last item needs a little explaining. A return of capital can be “constructive,” in that the proceeds represent unrealized capital gains and don’t erode the value of the fund. Or they can be “destructive” in that the fund is simply giving investors their own money back.
Even destructive return of capital isn’t necessarily destructive nor nefarious. CEFs will often smooth out their distributions to give their investors an even income stream, and sometimes this might mean distributing more than current earnings would support. If it is temporary, it’s generally not a problem. But keep an eye out for it. If return of capital makes up a large proportion of the CEF’s distribution, they might need to cut the distribution in the not-too-distant future.
The varied mix of income sources mean that your distributions will be taxed at different rates, all of which will be broken down on the 1099 you receive from your broker.
In the case of municipal bond CEFs, the vast majority of your distribution will be classified as tax-free. You would only have taxable income if the fund sold bonds and generated realized capital gains, in which case you would owe taxes at the short- or long-term capital gains tax rate. And any return of capital would lower your cost basis, thus setting you up for capital gains in the future when you eventually sell your shares.
For taxable CEFs, your distribution will be a mixture of dividends, ordinary income (interest) and short and long-term capital gains. As with tax-free muni funds, in the event of return of capital you will also have a lower cost basis, which will come into play when you eventually sell.
The Best Closed-End Funds You Can Buy
With that as background, let’s now take a look at the best closed-end funds to buy in 2023.
As with any investment strategy, diversification is critically important. So, we’re going to cover a variety of CEFs, including both equity closed-end funds and fixed-income closed-end funds.
1. Eaton Vance Municipal Income 2028 Term Trust (ETX)
- Type: Tax-free municipal bond
- Assets under management: $200 million
- Expense ratio: 1.36%, or $136 per year on $10,000 invested
- Distribution rate: 4.0%
Let’s start with a good tax-free municipal bond CEF, the Eaton Vance Municipal Income 2028 Term Trust (ETX).
ETX is a special type of closed-in fund called a “term fund.” This simply means the CEF has a shelf life, and at the end of that life it will liquidate and return its cash to shareholders. ETX intends to cease its investment operations on or about June 30, 2028, giving us a little over six years.
You might be wondering why the fund would choose to liquidate, and the answer is simple. Closed-end funds often trade at discounts to net asset value. That might seem good: After all, value investors buy underappreciated assets, waiting for them to improve in price as other investors realize their worth. But in the absence of a catalyst, discounted CEFs can stay at a discount forever.
That’s where term funds come into play. Term funds liquidate at net asset value. That means that, as the CEF approaches the end of its term, the discount should naturally close. This gives investors a degree of safety that doesn’t exist in traditional closed-end funds.
At current prices, ETX trades at a 4.7% discount to net asset value. That’s not huge by CEF standards, but term funds generally trade at smaller discounts than the CEF average. And at current prices, ETX yields a tax-free 4.%. If you’re in the 32% tax bracket, that’s equivalent to a 5.9% taxable yield. Not too shabby!
2. BlackRock 2037 Municipal Target Term Trust (BMN)
- Type: Tax-free municipal bond
- Assets under management: $134 million
- Expense ratio: 2.05%, or $205 per year on $10,000 invested
- Distribution rate: 4.5%
This is Young and The Invested, of course. If you are reading this, chances are good that you have not years but decades until retirement.
So, let’s take a look at another term fund: the BlackRock 2037 Municipal Target Term Trust (BMN).
Target term funds are slightly different than term funds. A term fund simply liquidates at a fixed point in the future. A target term fund liquidates at a fixed point in the future and at a targeted price. BMN’s objective is to liquidate on or around Sept. 30, 2037, and return exactly $25 per share. (For reference, BMN trades at $24.90 as I write this.)
That $25 is not guaranteed, of course. And there is no promise the managers will be successful in getting there. But that is their goal, and it’s relatively simple to structure a bond portfolio so that it matures on a specific date with a known par value.
At current prices, BMN trades at a roughly 3% discount to net asset value and yields 4.5%. Assuming a 32% tax bracket, that’s a 6.6% tax equivalent yield.
BMN is a new fund, having launched in late October 2022. The timing couldn’t have been better, as the fund was building out its portfolio just as long-term yields were hitting multi-year highs. What better time to start than when yields are high and prices are low?
Accredited Investments to Consider for Your Portfolio
Minimum Investment: $50,000
Minimum Investment: $2,500
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Minimum Investment: $5,000
3. BlackRock Floating Rate Income Trust (BGT)
- Type: Floating-rate income
- Assets under management: $254 million
- Expense ratio: 1.62%, or $162 per year on $10,000 invested
- Distribution rate: 8.3%
2022 saw bond yields surge higher, which wreaked havoc on many fixed-income portfolios. (The math on bonds is simple: If bond yields go up, then prices come down, and vice versa.)
One way to minimize this seesaw effect is to focus on floating-rate securities. These bonds have regular resets that tie the coupon payment to prevailing market interest rates. So, as market yields rise, so does your payout!
The flipside, of course, is that falling yields mean a smaller payout. So, the degree to which you want to own floating rate securities ultimately comes down to what direction you expect interest rates to trend. But regardless, having at least a little exposure to floating rates makes sense, if for no other reason than to offer diversification.
One solid option is the BlackRock Floating Rate Income Trust’s (BGT). BGT is required to invest at least 80% of its assets in floating- and variable-rate instruments. The average effective duration of its portfolio is not expected to be more than 1.5 years. In plain English, that means that a 1% rise in market interest rates would translate to just about 1.5% in capital losses, or a 1% drop in market interest rates would translate to about 1.5% in capital gains.
In other words, don’t expect this CEF to get whipped around if we have another year of volatility in bond yields.
At current prices, BGT trades at a massive 11% discount to net asset value, meaning you’re buying its assets for 89 cents on the dollar. On top of that, it yields a very attractive 8.3%.
4. BlackRock ESG Capital Allocation Trust (ECAT)
- Type: ESG multi-asset
- Assets under management: $1.5 billion
- Expense ratio: 1.35%, or $135 per year on $10,000 invested
- Distribution rate: 8.2%
Let’s take a break from pure bond funds and move in the direction of equities.
One of the biggest trends of recent decades has been a focus on investing in companies with good environmental, social and corporate governance (ESG) policies in place.
This isn’t merely about feeling good or checking the right boxes. Over time, numerous studies have shown that companies that rate highly on ESG scores tend to perform as well or better than their peers, particularly on social and corporate governance issues. Companies that have good labor relations and are shareholder-friendly tend to have fewer costly labor disputes, fewer clashes with government regulators, better worker morale, and are less likely to excessively reward their executives at the expense of their workers and their shareholders.
With that said, let’s look at the BlackRock ESG Capital Allocation Trust’s (ECAT). ECAT is required to invest at least 80% of its portfolio in the securities of companies that rate highly based on environmental, social and governance factors.
ECAT is a multi-asset fund, with about 64% of its portfolio currently allocated to stocks and 47% allocated to fixed income. And if you did the quick math in your head, yes, that works out to 111%. Well, that extra 11% represents the value of certain derivatives the fund trades, in addition to a modest amount of leverage. The fund also writes (sells) options as a way of generating additional income.
At current prices, ECAT trades at a massive 16% discount to net asset value and yields a whopping 8.2%.
5. BlackRock Utilities, Infrastructure, & Power Opportunities Trust (BUI)
- Type: (large-cap stock)
- Assets under management: $489 million
- Expense ratio: 1.08%, or $108 per year on $10,000 invested
- Distribution rate: 6.6%
For a balanced, income-oriented equity closed-end fund, consider the BlackRock Utilities, Infrastructure & Power Opportunities Trust (BUI). The fund invests primarily in equity securities issued by companies in the Utilities, Infrastructure, and Power Opportunities sectors and invests both in the United States and globally.
Currently, about 58% of its portfolio is invested in American securities, with France, Italy, and Germany accounting for 6%, 5%, and another 5%, respectively. All other countries are in the low single digits. In addition to the stocks it holds, this CEF also writes (sells) options to generate additional income.
Considering it has “utilites” in the name, you might think BUI’s portfolio was stuffy and boring, but nothing could be further from the truth. Some of the fund’s largest holdings include leading renewable energy companies such as Vestas Wind Systems (VWDRY) and blue-chip pipeline operators like Kinder Morgan (KMI).
BUI rarely uses leverage, and it runs a pretty conservative stock portfolio. At current prices, the fund trades at a respectable 5% discount to net asset value and yields a competitive 6.6%.
6. Neuberger Real Estate Securities Income Fund (NRO)
- Type: REITs and preferred stock
- Assets under management: $167 million
- Expense ratio: 2.06%, or $206 per year on $10,000 invested
- Distribution rate: 10.7%
2022 was not a good year for real estate investment trusts (REITs). Because REITs have always had a major emphasis on income, investors came to view them as a bond substitute over the past 20 years. But when bond yields surged last year—and bond prices collapsed—REIT prices also fell in sympathy.
It remains to be seen what direction bond yields go in 2023. But either way, REITs could mount a strong recovery. If yields fall—and bond prices rise—then REIT prices should also benefit. But if inflation proves to be stubborn and yields continue inching higher, REITs should be in a better position than they were a year ago, as the rents they collect from tenants should also trend higher in line with inflation.
One way to play a recovery in REITs is via the Neuberger Real Estate Securities Income Fund (NRO). The CEF has about 63% of its portfolio in REIT common shares and another 34% in REIT preferred shares (high-yield “hybrid” securities that have features of both stocks and bonds). The remainder is in cash, meaning the fund is unleveraged at the moment.
Regardless, NRO yields a massive 10.7% at current prices and trades at a 6% discount to NAV.
Best Accredited Real Estate Investments to Consider
Minimum investment: $500. Fees vary by offering.
Minimum Investment: $5,000. Fees vary by offering, but typically are 1%.
Minimum Investment: $50,000. Fees vary by offering.
7. Gabelli Dividend & Income Fund (GDV)
- Type: Large-cap stock
- Assets under management: $2.0 billion
- Expense ratio: 1.28%, or $128 per year on $10,000 invested
- Distribution rate: 6.1%
For one final equity closed-end fund, consider the Gabelli Dividend & Income Trust (GDV). Founded by legendary growth investor Mario Gabelli, GDV has been up and running since 2003. GDV is required to invest at least 80% of its assets in dividend paying or other income-producing securities, though yield is not the only consideration—the fund also looks for capital gain potential.
While the U.S. accounts for the bulk of its portfolio, at nearly 80%, the fund regularly invests overseas, and its single largest holding is Swedish tobacco company Swedish Match AB (SWMAY).
Furthermore, while the fund looks for dividend-paying stocks, it doesn’t necessarily look for ultra-high yielders. Mastercard (MA) and Microsoft (MSFT) are two of its largest holdings, and they sport current dividend yields of 0.6% and 1.1%, respectively. So, you can think of the Gabelli fund as a growth-oriented stock fund that also happens to throw off a lot of income.
At current prices, the fund trades at a gargantuan 14% discount to net asset value and yields an attractive 6.1%.
Historically, it is rare for GDV to remain at a discount to NAV of this size. Whenever the discount has gotten close to 15%, it has generally reversed to 5% to 10% in fairly short order.