I wrote the following for Retirement Income Journal...
Yield through Closed-End Funds?
some, it’s a necessity. For others, it’s driven by a fond remembrance of yields
past. Whichever. A desperate search for yield has gripped older investors. And
that in large part explains the recent surge in closed-end funds.
the number of new closed-end funds (CEFs) launched and the money going into
closed-end funds are at record highs. In one month (March) alone there were
four launches. “The CEF industry market size has increased to $288 billion,
dispersed among 583 funds that are managed by 103 different asset managers,”
according to a June report from Cerulli Associates.
course, we all know that finding yield, even in today’s low-interest
environment, is not really very hard. If you want a 12% return right now, you
can buy 10-year bonds from the government of Greece. But there’s a catch. With
high return comes high risk. Do CEFs, some of which offer yields similar to
Greek bonds, offer any lesser risk?
Markets tend to be efficient. But that’s not to say that closed-end funds are
bad. Just move in with eyes wide open. The risk of buying Greek sovereign bonds
is readily apparent (huge government deficits, riots in the streets, the
potential for default). There’s no free gyro lunch.
there’s no free lunch in closed-end funds, either, although the risks are not
always so visible. As with any fund, open or closed, you assume whatever risks
are inherent in the asset class. So if you buy a high-yield bond CEF, for
example, you risk that the underlying high-yield bonds may default en masse or,
alternately, plummet in value should interest rates rise. You are also subject
to managerial risk, as CEFs tend to be quite actively managed. And your account
value is subject to the management fees of CEFs, which tend to be significantly
higher than those of open-end funds.
there are the subtler dangers:
Because CEFs issue a fixed number of shares, demand may drive the share price
higher than the net asset value (NAV) of the underlying holdings. That’s called
a premium. Conversely, if the fund owners throw an IPO party and no one comes,
the share price may dip below street level. That’s called a discount.
you buy shares at a premium, or even at a modest discount, you risk seeing
those share values fall, regardless of how the underlying holdings perform.
According to my Morningstar Principia software, about 120 CEFs currently sell
at a premium, and many others are near par. Beware.
Leverage. Many CEFs (about
two-thirds, or 400, per Morningstar) borrow money to create leveraged
positions. That’s often how certain funds deliver great yields. But, of course,
leverage magnifies losses as well as yield and performance. Many of the
leveraged high-yield CEF bond funds now selling at a premium, largely for their
juicy 10% to 12% yields, took enormous hits in 2008. In some cases, those hits
exceeded the 40% or so loss that stocks suffered.
capital to raise yield is something that rarely happens in the mutual-fund
world, and when it does, it is clearly brought to investors’ attention.
Vanguard, for example, has three funds with the words “managed payout” in the
name. In the world of CEFs, “managed payouts” are not trumpeted. Check
carefully to see whether the “distribution rate” includes a return of capital.
If it does, your cherished yield may be little more than smoke and mirrors.