The “Other” Exchange Traded Fund

Exchange-traded funds (ETFs) have become popular in this century, due largely to relatively low expenses and tax efficiency. As the name indicates, ETFs trade like stocks, on an exchange, as opposed to mutual funds, which typically are bought from and sold to the sponsoring company. Often, ETFs track a particular market index.
Less publicized these days are what might be considered the original exchange-traded funds, known as closed-end funds. Closed-end funds also issue a certain number of shares, which trade between investors on a stock exchange. Rather than mimic an index, closed-end funds usually are actively managed, in an effort to deliver superior returns to investors.

The case for closed-ends

Should investors put money into closed-end funds? Perhaps. Some closed-end funds have excellent long-term records, including some that specialize in a certain area, such as a single foreign country’s stocks.
In addition, specific features of these funds might appeal to investors. For instance, closed-end funds frequently trade at a premium or a discount to net asset value (NAV).
Example 1: CEF closed-end fund holds stocks of various companies; the current market value of those shares is $100 million. Ten million shares of CEF are outstanding. Thus, the NAV of CEF is $10 per share ($100 million divided by 10 million).
Nevertheless, CEF now trades at $9.25 a share: a 7.5% discount to its NAV. Over the past year, CEF has sometimes traded at a larger discount, sometimes at a smaller discount, and sometimes even at a premium to its current NAV.
Among the universe of closed-end funds, it’s typical for investors to see a range of premiums and discounts, which can change at any time. Some investors will study a desirable closed-end fund for some time, observing its discount/premium range. When the fund is nearest its widest discount to NAV, there may be a buying opportunity, and a chance to profit if the discount narrows, beyond the normal profit potential of investing in securities. There’s also risk, if the discount should become even larger, in addition to the usual market risk that a share price might drop.

Using leverage

In addition, buying closed-end shares at a discount can raise the dividend yield to investors. If CEF holds companies with an average dividend yield of, say, 4%, and investors can buy at a 10% discount to NAV, the dividend yield would go up to 4.44%: an annualized 40 cents a share, on a $10 NAV, if CEF is purchased at $9 a share.
Some closed-end funds go even further to boost yields to investors. They use leverage to buy more shares, perhaps by borrowing money or issuing preferred shares or using other tactics. Closed-end bond funds may be likely to follow such a plan.
Example 2: LEV closed-end fund issues $100 million worth of common shares and leverages the fund by issuing $50 million of preferred shares, paying 3% to investors. Then, LEV uses the total $150 million raised to buy municipal bonds with an average yield of 5%.
The $150 million of municipal bonds will pay $7.5 million a year in interest at 5%. LEV will pay $1.5 million to its preferred shareholders: 3% of $50 million. That will leave $6 million ($7.5 million minus $1.5 million) for investors in the common shares. The latter investors will get a 6% return on their $100 million outlay, even though LEV holds bonds yielding 5%. Leverage can benefit investors, but such practices also can add to losses in a down market, so investors should proceed with care.
Information about these funds is available from the Closed-End Fund Association at

IRAs – Quick Refresher

Here is a quick refresher for IRA contribution information for 2016 and 2017:

• For 2016 and 2017, total contributions to traditional and Roth IRAs cannot be more than $5,500, or $6,500 for those age 50 or older.
• IRA contributions can’t exceed taxable compensation for the relevant year.
• Contributions to a traditional IRA are prohibited for those 70½ or older. Contributions to a Roth IRA are permitted, regardless of age.
• If married couples file a joint tax return, one spouse may be able to contribute to an IRA even without taxable compensation for the year. The amount of the couple’s combined contributions can’t exceed the taxable compensation reported on the joint return.

Hard-to-Value IRAs: Proceed with Caution

A new year begins with celebrations, resolutions, and dual IRA opportunities. Most workers and their spouses have until April 18, 2017 (April 19 in some states), to contribute to an IRA for 2016. At the same time, contributions to 2017 IRAs are now permitted; the earlier money goes into the account, the more time for tax-deferred investment buildup.
While you consider IRA contributions, you should also take this time to review IRA investments. Virtually any investment can go into an IRA, other than life insurance and collectibles. In recent years, questionable outlooks for stocks, bonds, and savings accounts have encouraged many IRA owners to consider—or put money into—nontraditional IRA assets.

Assessing alternatives

Consequently, IRA owners can invest in real estate, venture capital pools, even their nephew’s Internet startup that hopefully will become the next Google. Such outlays may or may not prove to be good uses for retirement funds. In any case, however, some tax-related issues will arise.
IRAs must be valued for certain purposes, and illiquid assets are not as easy to value as listed securities or mainstream savings instruments. The IRS, which views undervaluation as a potential problem, has made some changes in reporting requirements, in order to spotlight alleged transgressions. IRA owners face painful consequences if they trigger IRS displeasure in this area.

Lower value, less tax

IRAs need to be valued for purposes such as required minimum distributions (RMDs) and Roth IRA conversions.
Example 1: Bill Carson, an experienced real estate investor, has most of his traditional IRA money in private real estate partnerships. Now that he is past age 70½, Bill must take RMDs from his IRA each year and pay tax on the distributions. The lower the value of the real estate, the less tax Bill will pay on his RMDs.
There is no readily visible market for the properties held by these private partnerships, and, thus, no way to easily value Bill’s IRA. The IRS may suspect Bill of lowering the valuation to reduce taxable distributions.
A similar situation may appear if Bill wants to convert his traditional IRA to a Roth IRA. Converting a traditional IRA with $500,000 in mutual funds to a Roth IRA will generate $500,000 of income to be taxed, but how much income will be generated when an IRA holding real estate assets is converted?

Cracking down

To prevent undervaluation that can lead to tax underpayments, the IRS is requiring more information from IRA custodians on Forms 5498 and 1099-R for 2015 and later years. On Form 5498, which is filed annually with information on IRA account value and whether a distribution is required, IRA custodians must reveal the presence of hard-to-value assets and the asset type. The same information is required on Form 1099-R, which reports the amount of any IRA distribution. (For Form 1099-R, this rule affects in-kind distributions of hard-to-value assets.)
With this information, the IRS will be able to focus on IRAs that hold illiquid assets, which are subject to RMDs. The agency can follow up to see if the reported valuation was arrived at fairly.

Impact on IRA owners

Individuals who want hard-to-value assets in their IRA, for their growth potential, should be vigilant about providing reliable valuations.
Example 2: Bill Carson’s IRA holds $100,000 in liquid assets as well as private real estate investments. Bill’s IRA custodian has listed Bill’s cost—$400,000—as the value of the real estate.
This year, Bill will be 71, so the IRS Uniform Lifetime Table gives him a “distribution period” of 26.5 years. Using the historical $400,000 cost of the real estate, Bill would divide the total account value ($500,000) by 26.5 to get an RMD of $18,868.
Now, however, Bill’s IRA custodian requires him to get a current appraisal of the real estate holdings in the IRA. Suppose the appraiser finds the real estate interests in Bill’s IRA are worth $750,000. This would drive the account value up to $850,000, as reported on Form 5498, and the RMD to more than $32,000. If Bill withdraws less, he could owe a 50% penalty on the shortfall.
For IRA owners, finding an IRA custodian that will hold hard-to-value assets can be a challenge. Once that’s accomplished, the next step may be discovering the custodian’s valuation policy. A custodian could require an IRA owner to provide a valuation once per year, from an independent source. A valuation might come from the sponsor of the deal, from an executive of a private company with stock in the account, or a reputable third party. For real estate, an annual comparative market analysis might be required.