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Closed-End Funds Beat ETFs, Mutual Funds

Stan Luxenberg

NEW YORK ( TheStreet ) -- Since the financial crisis, most mutual funds have delivered solid returns. But investors could have done even better with closed-end funds. During the three years ending in 2012, the average intermediate-term bond mutual fund returned 7.0% annually, compared to a return of 11.4% for closed-end peers, according to a Morningstar study. While emerging-markets mutual funds returned 4.3% annually, closed-end returned 6.7%. Most closed-end funds also topped comparable ETFs. The average foreign large value closed-end returned 5.7%, compared to 3.2% for comparable ETFs.
Morningstar analyst Mike Taggart says that the peculiar structure of closed-end funds has enabled them to get a big boost from the low interest rates of recent years. Like mutual funds, closed-end funds hold portfolios of stocks or bonds. But closed-end funds issue a limited number of shares that trade on stock exchanges. In contrast, traditional mutual funds can sell an unlimited number of shares.
Closed-end funds have gained an important edge because they can use leverage. In a typical deal, a fund starts by raising cash from investors. After investing the money in bonds or stocks, the closed-end portfolio manager can then borrow against the assets, taking a bank loan or issuing preferred shares. Using the proceeds of the borrowing, the manager buys more bonds or stocks. Many closed-end funds have leverage ratios of around 30%. So a fund that raised $100 million from investors would use borrowings to buy an additional $30 million in assets.
In the current low-rate environment, leverage is extremely profitable. A portfolio manager can pay 1% for a short-term loan -- and then use the cash to buy bonds that yield 4%. The extra income from the leveraged purchases boosts the fund's yield and total return. Regulators limit the ability of mutual funds to use leverage.

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Make no mistake, leverage can be risky. Just as it can magnify gains in a bull market, leverage can exaggerate losses in a downturn. If interest rates spike, then closed-end bond funds could crater. Even in flat markets, leverage can make funds volatile.
Morningstar's Taggart notes that some closed-ends suffered huge losses during the financial crisis. But he says that investors who had the stomachs to hold through the rough times were rewarded as the markets rebounded.
Should you consider closed-ends now? Perhaps. If you believe that the Federal Reserve will keep its pledge to hold down interest rates into 2014, then closed-ends are worth considering. In an environment where rates stay flat -- or rise just a bit -- leverage should remain profitable, and closed-ends should continue outdoing mutual funds and ETFs. But keep in mind that if rates spike, the cost of leverage would climb and hurt closed-end returns.
To find funds that can thrive in a period of low rates, look for closed-ends with strong long-term performance records and substantial leverage. A solid choice is Aberdeen Asia-Pacific Income FAX , which invests in bonds from Australia and such Asian countries as Korea and Indonesia. The fund yields 5.4%. During the past five years, Aberdeen has returned 12.2% annually, outdoing 70% of global bond funds. Most of the fund's assets are invested in investment-grade government bonds. Aberdeen has 16% of assets in bonds that are rated below-investment grade. Those give higher yields, but come with extra risk.

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Stock investors can consider Gabelli Equity Trust GAB . During the past ten years, the closed-end fund has returned 10.4% annually, outpacing the S&P 500 by 2 percentage points. Veteran portfolio manager Mario Gabelli has long been known for his distinctive style of value investing. Gabelli favors companies with solid balance sheets that sell for less than what private investors would pay to acquire the entire businesses. The fund currently has a big stake in industrials. Holdings include farm equipment giant Deere DE and machinery maker Honeywell HON .
At the time of publication the author had no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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