Live by the sword, die by the sword. That could be the motto of closed-end funds (CEFs).
They have long been a valued source of retirement income. That’s largely due to the use of leverage, or borrowed money to buy securities, by many CEFs. Eighty percent of fixed-income CEFs use leverage, as do 53% of equity CEFs, according to Tom Roseen, Head of Research Services for Thomson Reuters Lipper.
“They have enticing yields because they use leverage,” said Cara Esser, an Associate Director of Morningstar Research Services. But leverage also can make them more volatile. “Leverage not only magnifies their gains, it also magnifies their losses,” Roseen said.
Their 12-month yields averaged 6.07% as of April 30, according to Lipper Inc. Some CEF categories averaged yield above 8%. In contrast, the yield on 10-year Treasuries was a meager 2.29%. Five-year certificates of deposit paid a paltry interest of 0.89% on average, according to Bankrate.com.
Equally enticing, a few CEF categories also enjoyed total returns over the past 12 months that outperformed the broad stock market’s return as measured by SPDR S&P 500 ETF ( SPY ), which tracks the popular market benchmark. They also provided a yield well in excess of SPY’s 1.9% 12-month yield.
So why aren’t more shareholders stampeding into CEFs? In fact, CEFs can be an effective way to play the market for retirement income – in some cases, for income plus price appreciation – if you understand the risks that can cost you money with CEFs.
Start with that use of leverage. Funds can borrow money and they can issue preferred stock. CEFs can issue much more preferred stock than regular open-end funds can. Seventy-seven percent of CEFs are leveraged, Esser says. Among leveraged funds, the average leverage ratio is 29%.
CEFs aim to borrow at low short-term rates, then invest in securities whose yield is higher, typically because it is based on longer-term rates.
IBD’S TAKE:For help figuring out whether you are saving enough for retirement at your age and income, check out the easy-to-read table in this IBD report.
Discount To NAV
Differences in how CEF and regular mutual fund shares are priced also plays a role in how you decide whether to invest in a CEF and which one.
To understand the strategy, you must understand why different factors govern their pricing.
In the case of regular open-end mutual fund shares, you buy shares from the fund itself. The fund issues new shares when investors bring in new money, and they redeem, or remove, shares when investors withdraw money. The number a funds shares outstanding can change daily.
A CEF issues a fixed number of shares that trade on a stock exchange, like a stock or an ETF. Except for the initial public offering, you buy existing shares from other shareholders, typically through a broker.
Shares in both closed- and open-end funds reflect the cumulative value of underlying holdings after fees, divided by the number of outstanding fund shares. That’s their net asset value or NAV. But the price of a CEF also reflects shareholder demand. When demand drives up the share price, a CEF can trade at a premium to its NAV. When demand is slack, a CEF can trade at a discount to its NAV.
“Along with leverage, that can make closed-end funds more volatile” than regular mutual fund shares, says Michael Hedstrom, director of the Closed End Fund Association (CEFA), a trade group.
Some CEFs habitually trade at a discount to NAV except when demand is unusually high.
Shareholders typically want to buy a CEF when it’s trading at a discount. “It’s like buying a dollar for 95 cents,” Roseen said.
Morningstar’s Esser advises investors to compare a CEF’s current discount with its longer-term average discount. That’s more useful for helping you decide on the potential of a current discount to shrink, she says.
Since CEFs so often trade at a discount, “we don’t care what the (current) discount if you’re going to hold the CEF a long time,” she said. That presumes an attractive expected rate of return.
The webpage at Morningstar.com for each CEF shows current and six-month discounts and premiums.
You can also find year-by-year discounts and premiums as well as highs, lows and averages.
In addition, you can see what Morningstar calls the “Z-Statistic” for six months, one year and three years. A negative z score means the current discount is lower than usual, and vice versa.
At the CEFA.com website, you can find other factors for individual CEFs. One is the percentage of a fund’s assets that are leveraged or purchased with borrowed money. That can magnify a fund’s gains and yield, but it can also magnify losses. It’s especially risky at a time of rising interest rates, like now.
Beware Of Cannibals
Another factor shown on the CEFA site is a fund’s income yield and its distribution yield. Distribution yield can include return of capital and generally should be avoided. Depleting capital can cannibalize a CEF’s share price over time.
So who should consider investing in a CEF? “They’re best for people who are comfortable actively managing their portfolios,” Roseen said. “They’re not for people who want set-it-and-forget-it investments. They’re for people who are looking for above-average income opportunities, who are willing to take on above-average risk.”
One way to seek the benefits of CEFs while diluting the risks of individual CEFs: Invest in an open-end mutual fund or an exchange traded fund that specializes in holding CEFs.
Among such ETFs are First Trust CEF Income Opportunity ( FCEF ), First Trust Municipal CEF Income Opportunity ( MCEF ), PowerShares CEF Income Composite ( PCEF ), VanEck Vectors CEF Municipal Income ( XMPT ) and Morningstar US All CEFs (CEFS).
Like open-end mutual funds, ETFs are also cousins of CEFs. And investing in CEFs via ETFs can save you the trouble of trying to pick the most suitable CEFs in any given niche, whether it is high yield, U.S. stocks, utilities or another. Instead, you let a professional manager make those choices for you. It also boosts your diversification.
Among open-end funds, $112 million Matisse Discounted Closed-End Fund Strategy (MDCEX) also hold CEFs in their portfolios. So do $376 million RiverNorth Core Opportunity Fund (RNCOX), $2.1 billion RiverNorth DoubleLine Strategic Income (RNDLX) and $84 million Rivernorth/Oaktree High Income (RNOTX).
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.