Opening your search for yield to the closed-end fund market
Given the dominance of the $15.7 trillion1 (open-end) mutual fund market, U.S. investors tend to overlook another viable vehicle for pooling their assets—the closed-end fund.
Registered under the Investment Company Act of 1940, both types of funds share an essentially uniform purpose. Nuanced structural differences, however, create contrasts with interesting implications for investors, especially right now. In a global environment characterized by low yields, low economic growth, and low expected returns, many closed-end funds offer distinctive features—managed distributions, leverage, and discounted market values—that may be particularly suited to address these challenges.
Closed-end funds are often designed to dispense regular, robust cash flows
A key reason investors seek out closed-end funds is the comparatively high monthly or quarterly payments they tend to generate. While not guaranteed, these distributions—which can be implemented in fixed-dollar-per-share or percentage-of-assets amounts—allow closed-end funds to produce relatively predictable and strong cash flow streams that few mutual funds can match. Even equity-oriented and multi-asset closed-end funds, which aren't often sought out by yield-seeking investors, can generate high distributions within a closed-end fund structure. Closed-end equity funds often employ managed distribution policies that can help increase their distribution rates, as those policies allow the use of realized capital gains as a component of the regular distributions.
Last year, closed-end funds distributed $16.8 billion to their shareholders, about 6.4% of the $261.0 billion in closed-end fund assets as of December 31, 2015.2 Bond closed-end funds accounted for 62.0% of total closed-end fund assets at year end, which partially explains the fairly generous distribution level at a time when the U.S. Treasury note finished the year with a 2.3% yield.3 Regardless of the asset class, closed-end funds can draw on a range of sources to create cash flows for shareholders—income from interest and dividends, realized capital gains, and, if need be, return of capital—and many income-seeking investors find this added flexibility an attractive feature.
Leverage magnifies return potential for those comfortable with the incremental risk
Another advantage, subject to certain regulatory limits, is that closed-end funds have the ability to use leverage as a component of their investment strategies, which can potentially increase distributions as well as total returns. Nearly two-thirds of closed-end funds employed some form of leverage in 2015.2 Leverage—typically from bank borrowings, issuing debt, or holding certain derivative instruments—essentially allows a closed-end fund to assume more than 100% investment exposure. The idea is to borrow assets and invest them at a rate of return expected to exceed the borrowing costs. Because there's no guarantee that the return on assets will be higher than the borrowing costs, leverage increases the level of risk and, potentially, price volatility. However, leverage may also allow a closed-end fund the opportunity to generate more income and higher long-term returns—a trade-off some investors may be willing to accept at a time when such opportunities remain scarce.
Amid few investment bargains today, discounts pervade the closed-end fund market
Additionally, a feature unique to closed-end funds allows them to frequently post higher yields than comparable mutual funds holding similar underlying assets: Unlike a mutual fund, which continually creates and redeems shares directly, closed-end funds typically issue a fixed number of shares that then trade in the secondary market. Depending on the level of demand for that fixed supply, a share of a closed-end fund may trade at a discount or premium to its net asset value (NAV), the value of the share's proportion of underlying assets minus liabilities. All else being equal, a share purchased at a discount increases the yield relative to what it would have been otherwise. It also creates the potential for greater capital appreciation if the discount subsequently narrows.
According to the Investment Company Institute, the closed-end fund universe ended 2015 with its average share trading at a discount to NAV, which isn't uncommon: By asset class, the average discount ranged from 4.6% for municipal bond funds to 11.9% for global/international equity funds.2 More recent data from Morningstar revealed that 74.0% of all closed-end funds on U.S. stock exchanges traded at a discount, with a median discount of 5.8%. For historical context, the median discount for closed-end funds over the past 15 years has averaged 5.1%.4 While some of the discounts within that universe have since narrowed, there's no guarantee that a closed-end fund share discount will ever converge to NAV or swing to a premium. However, many closed-end fund sponsors can and do take steps in an effort to reduce discounts; these measures can include raising the distribution target, share repurchase (or buyback) plans, and periodic tender offers to allow existing shareholders to redeem at NAV.
In today's era of stretched valuations across many mainstream asset classes, sluggish economic growth, and anemic yields around the world, the closed-end fund market offers investors an increasingly rare opportunity to search for investments on sale that also deliver high distribution rates.
1 Investment Company Fact Book, Investment Company Institute (ICI), 2016. 2 "The Closed-End Fund Market, 2015," ICI Research Perspective, April 2016. 3 U.S. Department of the Treasury Resource Center, August 2016. 4 Morningstar Direct, based on 547 closed-end funds, June 2016.