Closed-end mutual funds can offer “stocks at a discount,” but you won’t likely hear about them from your broker.

Given their pluses, it’s a wonder why brokers so rarely recommend closed-end funds. There’s a simple reason for this: while closed-end mutual funds can benefit individual investors, brokers benefit more by putting their clients in conventional, open-ended funds.

Closed-end mutual funds are a lot like conventional, open-ended mutual funds. They hold a diversified portfolio of stocks, chosen by a fund manager who gets a fee for his or her services. The key difference is that open-ended funds stand ready to sell new fund units, or redeem existing fund units, on demand.

Closed-end funds also invest in a portfolio of securities but work with a fixed asset base. The value of their assets rises and falls, depending on how they invest. Their units trade like stocks, and mostly on a stock exchange.

Closed-end mutual funds may trade above their net asset value, or “at a premium,” as brokers say. But they mostly trade at a discount. If you buy them at a 10% discount, for example, and sell at the same discount many years later, you haven’t lost anything. But discounts on closed-ends sometimes shrink or disappear altogether. That happens when the funds liquidate, for instance, or convert to open-ended funds. But when that happens, you can earn a profit of 10%, 20% or more, virtually risk-free.

Brokers go where the money is

If a broker sells you a closed-end mutual fund, they may charge you a 2% commission. (Individual brokers get to keep perhaps a third of the fees and commissions they bring in.) But the broker won’t earn another dime on that asset until you sell, possibly many years later.

On the other hand, if a broker sells you a conventional mutual fund, the broker can earn a steady stream of yearly trailer fees of 0.5% to upwards of 1.0%. Sometimes they get an immediate back-end load of up to 6% of your investment.

So you shouldn’t be surprised that brokers and brokerage-firm analysts respond to these incentives by favouring open-end mutual funds over closed-end mutual funds.

To succeed as an investor, you need to stay alert for these conflicts of interest. You need to keep in mind that some brokers will resolve them by favouring their own interests over those of their clients.

Here are three tips for buying closed end mutual funds

1. Get out of buying “theme” closed end mutual funds

   If the closed end mutual fund has a theme that seems to be plucked from the headlines, you should stay away from it. It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines.

   Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices— perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the mutual fund’s performance. But when a fad fades, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

2. Get out of closed-end funds that invest in bonds

   Many bond funds built great performance records in the last decade. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates are low right now, but could move upward over the next few years as the economy recovers or in response to inflation fears. This is another way of saying that bond prices could fall.

   When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are down closer to 4%, it makes a lot less sense, and has a greater impact on your closed end mutual fund’s performance.

   The bond market is highly efficient, and we doubt that any bond mutual fund’s performance can add enough to offset its management fees. In addition, investing in a closed-end bond fund exposes you to the risk that the manager will gamble in the bond market and lose money.

3. Beware of buying vaguely described closed end mutual funds

   Stay out of closed end funds that show wide disparities between the fund’s portfolio and the investments that the sales literature describes. Some fund operators describe their investing style in vague terms.

   It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the fund takes on a lot more risk than you’d expect, our advice is to get out.

Bonus Tip: Our best closed-end mutual fund advice:

We think that closed-end funds are okay to hold if you own them, but we have moved away from recommending closed-end funds in favour of lower-fee exchange-traded funds (ETFs). So we feel that most closed-end mutual fund investors should shift into ETFs wherever possible. (For that reason, we’ve shifted our focus in our  Canadian Wealth Advisor newsletter to ETFs.)

Some ETFs have a number of advantages over closed-end funds that invest in the same general area. They are more liquid than most closed-end funds, and have lower management fees.

Moreover, ETFs consistently trade at or very close to net asset value, unlike closed-end funds, which often go through wide swings in their discounts or premiums to the value of their assets. That discount could widen just when you need to sell your shares.

In Canadian Wealth Advisor, we help you steer clear of brokers’ conflicts of interest. You also stay current on ETFs, REITs, stocks and other investment bargains, plus many other issues for safely making more money.

What portion of your investment portfolio is made up of closed end mutual funds? Have they proven profitable against their open ended competitors? Share your experience with us in the comments.