Advisers on the hunt for income should be keeping a close eye on the closed-end-fund space, where yields are double and triple those of traditional mutual funds and exchange-traded funds.
The average equity closed-end fund has a yield of 5.7% while the average equity income mutual fund has a yield of 2.3%, according to Morningstar Inc.
Many advisers overlook the income opportunity in closed-end funds, though, because of the unique structure of the funds, Anne Kritzmire, managing director of closed-end funds at Nuveen Investments, said at a conference in New York last week.
“The income benefit is what resonates the most with investors, but the biggest hurdle is advisers [who] don't understand them,” she said at the Capital Link Close-End Fund Forum. “Closed-end funds give you more and that means more complexity.”
Closed-end funds have a fixed number of shares that trade intraday on an exchange. Because the amount of shares is finite, they tend to trade at a discount or premium to the net asset value of the fund's underlying securities.
The funds also are able to use leverage — something traditional mutual funds don't do — as the primary way they boost their income distributions.
Leverage is a double-edged sword, though.
“Leverage enhances yields and adds more volatility,” said Mariana Bush, a closed-end fund and exchange-traded-products analyst at Wells Fargo Advisors. “For some advisers, that would be one reason to stay out of the fund; for another, it could be a reason to stay in. Closed-end-fund investors should probably be longer-term oriented.”
One thing advisers can do to protect themselves when looking at closed-end funds is to make sure the yield promise isn't too good to be true, Ms. Bush said. An unreasonably high yield, say, more than 10% for an equity fund, could be a sign the fund is stretching too far in its search for income, she said.
Since the start of the year, investors have shown greater interest in closed-end funds. The two largest initial public offerings of closed-end funds since 2007 occurred in the first four months of the year.
The Pimco Dynamic Credit Trust Income Fund (PCI) raised $3.2 billion in January and the DoubleLine Income Solutions Fund (DSL) raised $2.3 billion last week.
While both of those funds are taxable bond funds, some experts say the best values in the closed-end-fund space are among the equity funds. The average equity closed-end fund was trading at a 4% discount to its net asset value as of the end of day Friday. The average taxable bond fund was trading at a slight premium at the same time.
“One of the things we look at is discount valuation,” Ms. Bush said. “It helps us avoid areas that are overbought.”
As a result, the select list at Wells Fargo now includes “many more” equity funds than taxable bond funds.
Advisers shouldn't let the discount scare them away, but it is something they need to keep an eye on, said John Cole Scott, a portfolio manager at Closed-End Fund Advisors.
“The discount doesn't have to narrow to make money,” he said. “It just can't widen dramatically.”
There's even a slice of equity closed-end funds that could appeal to leverage-averse advisers. Closed-end funds that write covered calls generate extra income by selling call options, instead of using leverage.
“If you're looking for income and equity exposure, it could be a good place to get it,” said Cara Esser, a closed-end fund analyst at Morningstar. “The biggest risk is, you don't get as much on the upside because you're writing away some of your profits with the call. The trade-off is, they won't lose as much, on a relative basis, in a down market.”
The average covered call equity closed-end fund has a 9% yield.
Dorothy Bossung, executive vice president at Lowery Asset Consulting LLC, finds closed-end funds appealing because of their income, but finds it easier to outsource the legwork to a third-party manager.
She uses closed-end fund strategies run by RiverNorth Capital Management LLC or Parametric Risk Advisors LLC.
“Some clients really, really focus on income generation,” she said.