Closed-End Funds Beat ETFs, Mutual Funds

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.

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.