Why Smaller CEFs Are Your Secret Weapon For Financial Freedom

Think about it for a moment: when was the last time you read anything about closed-end funds (CEFs), a way too often overlooked asset class that throws off 7%+ average dividends?

Never? Maybe once?

It’s a shame that CEFs are rarely discussed outside Wall Street circles, because they’re perfect for anyone who needs income these days. (And who doesn’t!?)

Smaller CEFs Give You Big Payouts And “Baked in” Upside

We’re going to bust through that barrier and look at how we can use CEFs to boost our income streams and our net worth, too.

We can dial ourselves in for even bigger gains when we focus on smaller CEFs. These “small fry” have less than a billion dollars in assets under management. And because they’re tiny and overlooked, a lot of them trade at very big discounts.

Also, these funds are too small to attract the attention of investment banks and hedge funds, because even if one of these big players bought one of these funds and it doubled, it would barely move the needle on their investment portfolios.

We’re fine with that, of course, because it leaves more room for us to scoop up bargains. There are three very simple reasons why smaller CEFs are a must-own for just about every investor:

  • Those huge yields—as I said, CEFs yield 7% on average, and some boast safe dividends as high as 10% or even more!
  • CEFs get you assets at a discount: Because CEFs are off the radar, they often trade at a market price below the value of their portfolios—something you never see in mutual funds and ETFs. When this happens, we say a CEF is trading at a discount to net asset value (NAV). Buying a CEF—particularly a small CEF—at a discount can send you on a wild profit ride as the discount vanishes, catapulting its price higher.
  • Many CEFs crush their indexes (in some asset classes almost all of them beat the indexes, some by a huge margin).

The rules of this game are pretty simple—and incredibly profitable:

  1. Buy a high-quality CEF at a big discount.
  2. Collect outsized dividends while you hold your CEF.
  3. Wait for the CEF’s discount to shrink or for it to trade at a premium.
  4. Collect your capital gains on top of the dividends you’ve been pocketing the whole while.

Some of your best opportunities in CEFs will come when a fund is in an established uptrend but, because of the inefficiencies in the CEF market, still trades at a big discount.

For example, look at the PIMCO Energy & Tactical Credit Opportunities Fund (NRGX), which has just $570 million in assets under management. It yields 5.4%, is up 66% in 2021 as of this writing and has crushed its index. Yet it trades at a 16% discount to NAV!

NRGX isn’t getting the attention it deserves because its smaller size keeps it off many CEF investors’ radar. But NRGX has traded at premiums to NAV as recently as early 2020; that history is another “tell” that a premium is on the table when CEF investors (inevitably) rediscover NRGX. When that premium arrives, it’ll inflate the price.

To show you our “discount slingshot” in action, let me take a real example. In August 2020, I issued a buy call on the Nuveen Real Estate Income Fund (JRS), a smaller CEF that sports a $357-million market cap as I write this. JRS holds large cap real estate investment trusts (REITs) like warehouse operator Prologis

PLD
(PLD),
apartment landlord AvalonBay Communities

AVB
(AVB)
and data-center REIT Digital Realty Trust (DLR). At the time, it traded at an outsized 14% discount to NAV. Just nine months later, that discount had been cut to 6.5%!

That’s a great trade on its own, but CEFs are cash machines, so investors got an eye-popping 9.8% annualized income stream while waiting for their 36% profits. Combine income and capital gains and the total return comes in at 45.1% over just nine months!

While this is possible with all CEFs, smaller funds like JRS are the best ones to target. Funds with total assets between $200 million and $1 billion, in many cases, get the fastest capital gains because a rush of investors can more easily move their prices. At the same time, they give us enough liquidity to get in and out as necessary.

And that’s just one reason why CEFs are a key to financial freedom. They also provide diversification (there are CEFs that get you into every corner of the world and just about every sector) and exposure to different asset classes (from high-yield and municipal bonds to individual sectors, like tech and healthcare stocks, and preferred shares).

Finally, because CEFs are run by often-well-connected managers, they give you access to assets that aren’t easily bought on open markets (like private equity in high-growth tech companies, for example).

Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report “Indestructible Income: 5 Bargain Funds with Safe 7.5% Dividends.

Disclosure: none

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