Best Closed-End Funds
July 24, 2012
Yield-starved investors have ventured into exotic – and often risky – assets, including hedge funds, non-traded REITs and private placements. But an asset class that has been around since 1893 offers a compelling combination of low risk and high income. A carefully selected portfolio of closed-end funds (CEFs) will yield 8% with less volatility than the S&P 500.
I’m not alone in paying renewed attention to this asset class. In late 2011, Burton Malkiel wrote an op-ed in the Wall Street Journal urging investors to replace traditional bonds in their portfolios with, among other things, leveraged municipal bond CEFs. Malkiel’s suggestion was especially notable given that he is known as a champion of simple portfolios constructed from low-cost market-cap weighted open-end mutual funds, an investment philosophy he most famously espoused in his classic book, A Random Walk Down Wall Street.
In this article, I will explore the general characteristics of CEFs and how to identify those that are the most attractive for income investors. While CEFs have additional complexity relative to open-end mutual funds, the best provide investors with very attractive income on a risk-adjusted basis. Lipper estimates, for example, that the average CEF is yielding 7.3%, although that claim should not be taken at face value (more on this later). Given the paltry yields in other parts of the capital markets, advisors and investors need to consider an allocation to these funds.
What is a CEF?
CEFs have many similarities to the open-end brethren. Investors can buy or sell shares of a CEF like a traditional open-end mutual fund. The fund manager charges fees against the assets in the fund for managing the fund’s holdings. Like an open-end fund, CEF shares are traded on an exchange, rather than through the mutual fund company that manages the fund.
But with an open-end mutual fund the manager creates or redeems shares to meet the balance of supply and demand. The key distinction of a CEF is that it has a fixed number of shares, which can be altered only if the manager does a secondary offering. The price of CEF shares often drift away from the net asset value of the fund holdings, trading at either a discount (less than the value of the fund’s assets) or at a premium (more than the value of the fund’s assets).
Morningstar has a useful resource center with a range of information about the basic attributes of CEFs. Readers who are unfamiliar with this fund structure will benefit from going through Morningstar’s slideshow that explains the basic attributes of CEFs. The Closed-End Fund Association (CEFA) is a trade group that provides a range of resources for researching these funds.
The tendency of CEF shares to trade at values that are quite different from the NAV of their holdings represents a challenge to financial theory. Burton Malkiel penned a 2005 article in which he referred to the persistence of differences between the prices of CEFs and their NAVs as one of the most enduring conundrums in the field of finance. This anomaly appears to violate the law of one price: How is it possible that a basket of securities (a share of the CEF) can trade at a substantially different price than do the assets in the basket?
Aside from the CEF discount or premium, investors need to understand other key characteristics of a CEF. There are different forms of income that CEFs generate: income derived from the underlying assets (so-called income-only yield) and the distribution yield or market yield, which may include dividend or coupon payments, short- and long-term capital gains, and return of capital. Income-only yield, if there is any income, is a component of the market yield. When the market yield is greater than income-only yield, it is often the case that the additional distribution to investors is simply return of capital.
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