One of the most popular investment choices for income investors are closed-end funds or CEFs. CEFs are great for individual investors because they offer diversified exposure to a host of different securities. For bonds in particular, CEFs are an excellent investment vehicle because they offer both diversification and liquidity in one low cost trading package; all things are generally problematic when buying individual bonds. Yet despite these advantages, many investors don’t really understand how to pick CEFs or what they should look for when buying a CEF. This article will go over the factors that are involved in choosing a CEF and why investors should not look at either yield or discount when buying CEFs (at least not isolation anyway).

For those investors interested in commentary on specific CEF opportunities, read this article on high yielding CEFs. or this article on current undervalued opportunities in the CEF space.

Now unfortunately most people who buy CEFs start by looking at either the yield or the discount on the CEF. Some investors also go so far as to check a CEF’s historical dividend payout to see if the fund has cut their dividend lately, and what the funds leverage is. A few investors will also look at the portfolio holdings in a CEF. These of course are all good things to do. But the most important steps in selecting a CEF are probably the following;

First, check the CEF’s discount relative to its own history and relative to peer CEFs, and

Second, check the composition of the CEF’s dividend payout to see if it comes from short term gains, long term gains, return of capital, or income.

To illustrate these two points, let’s examine a major CEF in global equities, an area that has been hit hard of late but which should be fine over time. The Eaton Vance Tax Managed Global Fund (NYSE:EXG ), pays a 10.2% yield and invests mainly in global equities. Careful investors will note that the fund’s dividend comes mainly from return of capital with only 10-20% of the dividend coming from income on the equities.

However, this practice by the fund is a long term trend suggesting that the return of capital is not driven by a need to make up for a recent income shortfall. Instead, the fund appears to be purposefully returning a small portion of its capital each period, probably under the theory that the capital returns are offset by generally rising stock prices which lead to unrealized gains across the rest of the portfolio. While it would be better from a dividend sustainability standpoint if the distributions were funded entirely from income, this situation is not uncommon among equity CEFs and isn’t a troubling sign. This view is supported by the chart below which shows the fund’s price and NAV over the last five years. Since NAV isn’t declining in a consistent and significant way, investors can take greater confidence in the dividend being sustained over time.

So one might conclude that EXG is a good long term income investment, but the question is still whether or not EXG is a good investment right now. Many investors will look at the discount/premium on the CEF and base their decision on that. Right now, EXG trades at

9% discount to NAV, meaning that investors are getting all of the underlying stocks in the portfolio at 9% less than their most recent end of business day price. This discount doesn’t tell us much though. For one thing, it’s not clear how this discount compares with the historical premium/discount in the fund, and for another, the discount could be driven by firm specific problems that result from the fund’s holdings. Too many investors simply buy CEFs because they trade at large discounts expecting those discounts to close over time. This can lead to those investors ending up holding funds like (OTCQB:FXBY ) and (OTCPK:FOFI ) both of which once had very small discounts and today have discounts north of 25%

In the case of EXG, it’s useful to look at the investments in the underlying portfolio as well as the historical and peer discounts. First, note that the fund holds investments in major international firms including Royal Dutch Shell (NYSE:RDS.A ) (NYSE:RDS.B ), Unilever (NYSE:UN ), Vodafone (NASDAQ:VOD ), etc. This is significant because it suggests that the fund’s holdings are not likely to be driving a long term permanent discount in the CEF.

Additionally, looking at the historical discount, it appears EXG has a 52 week discount/premium range from -15.7% to -7.4% with an average of -11.95%. These figures are extremely significant, because while there is a lot of research to suggest past stock prices cannot be used to predict future stock prices, this idea does not hold with CEFs. In fact, research has shown that CEF returns are the highest when their discounts are at least 1 standard deviation above the one-year historical mean of the CEF. So looking back at EXG, this is an OK time to buy, but not a great time since the discount is below the mean discount of

12%, and considerably below the widest discount seen over the past year of

16%.

The chart below illustrates EXG’s discount and premium over the last few years.

Now of course using a discount or premium relative to a fund’s own history is a good way to get into a CEF at an attractive price, but for long term investors, it is unlikely to make a big difference. Investors planning to hold a CEF for 5 years plus, see less than a 1% annual difference in returns whether they buy the fund at the high or low discount levels for the year. As such, long term investors are better off sticking with investments they are comfortable with, rather than obsessing over the price/NAV relationship.

For those investors who are new to CEFs and looking to apply the discussion from this article, some of the largest and most popular CEFs include the following: (NYSE:ACG ) — a diversified bond fund, (NYSE:DNP ) — a utilities fund, (NYSE:NUV ) — a muni fund, (NYSE:KYN ) — a natural resources fund, (NYSEMKT:FAX ) — a world bond fund, (NYSEMKT:EVV ) — a multi sector bond fund, (NYSE:ETY ) — an equity fund, (NYSE:NFJ ) — a dividend focused fund, and (NYSE:UTF ) — a utilities fund.

For those interested in non-muni CEFs that meet the criteria discussed here, read this article .