Why closed-end funds are more appealing during market turmoil

Current valuations and distribution rates mean long-term investors should take notice

Sep 22, 2015 @ 7:15 am

By Anne Kritzmire

On the roller coaster ride that is the current stock market, most financial advisers are understandably counseling clients against making any rash portfolio decisions. Panicking is often the worst move investors can make during such market mayhem.

However, smart investing opportunities can emerge even in broad market declines — opportunities that practically demand attention, or at least a serious look, from savvy investors and advisers. Being quick with a smart move isn't the same as being rash, and sometimes these opportunities lie in places or instruments that are less well-known. They shouldn't be overlooked — especially by investors with their eyes on the long-term prize.

Indeed, it can be dangerous to be too safe in the rapidly changing world we live in. The most dangerous risk may be not taking any risk at all. Advisers with income-oriented clients — especially those approaching or already living in retirement — should be watching carefully for long-haul investment gems that shine more brightly in periods of market turmoil.

One long-term investment option may be even more appealing right now than normal. This option is the closed-end fund, an exchange-traded cousin of the more familiar open-end mutual fund. Closed-end funds are a structure, not an asset class, and that structure is typically used in pursuit of high income and distributions.

Most closed-end funds offer diversified, actively managed investment portfolios and professional distribution management. In my opinion, their current valuations and distribution rates are quite compelling, and longer-term investors should consider them carefully.

Why CEFs are particularly attractive now

CEFs are generally designed to provide attractive regular cash flow over the long term. For that reason alone, they should be considered an essential part of a retirement income portfolio. They're “closed-end” because capital doesn't flow freely into and out of them, either when investors buy or sell shares. That means that, unlike mutual funds, the CEF portfolio manager doesn't have to sell portfolio investments to raise cash when investors get nervous and want to exit.

Closed-end funds have two “values” — their net asset value or NAV, which is the total value of their portfolio's investments, less liabilities, and their market price, which is the price that matches buyers and sellers on the exchange. So, when investors get nervous, instead of redeeming shares from their mutual fund company, they must sell shares on the exchange.

More sellers mean falling share prices and, usually, widening discounts — the difference between a fund's market price and its NAV. In late August, the average CEF discount widened to nearly 10% — more than double the market's long-term average discount of about 4.3%. While the funds' net asset values are also moving around, the magnitude is not the same. For knowledgeable investors, this can be that shining opportunity. Such investors buy CEFs when the discounts are wider than normal, and right now, discounts are certainly wider than normal.

Of course, “buying low” is a great way to start, but the real opportunity is a fund's cash flow potential over the long term. The majority of a typical closed-end fund investment's return will be due to its monthly or quarterly income and distributions. At today's discounts, the average taxable income CEF is yielding 8.5%, the average equity CEF is yielding 7.8%, and the average municipal bond CEF is yielding 5.8%, which is a taxable equivalent yield of 10.2% at top federal tax rates.

Like the old commercial, “But wait, there's more.” CEFs also give investors access to asset classes such as private placement stocks or thinly traded bonds, for example, which may not work well in a mutual fund that needs to invest in a hurry or raise cash quickly. These strategies and others may offer higher return potential in exchange for their lower liquidity, and they can help diversify other traditional income-oriented investments.

Finally, closed-end funds can convert the total return potential of real asset or equity strategies into smooth, persistent distributions that historically have outperformed inflation and can complement the income from a traditional bond portfolio. In experienced hands, those distributions can be tax-efficient, as well.

How do they do this?

Closed-end funds' income and distributions have historically been higher for three main reasons: Their unique structure lets them more easily employ leverage within regulatory limits, they can pursue a wider array of attractive investments with greater flexibility, and they can stay fully invested instead of holding cash that pays minuscule returns.

It's key to understand, however, that leverage is a multiplier, and in the current environment investors must be prepared for the greater extremes — higher highs, lower lows — a leveraged and exchanged-traded closed-end fund is likely to experience. For a patient long-term investor, however, magnifying the return of a strategy that has historically offered positive returns may be quite attractive, particularly if that return is professionally managed to become regular monthly or quarterly distributions.

The upshot?

What's the lesson here? It's that when the stock market is tumultuous, investors should indeed be cautious when mulling significant shifts in their portfolios. But rashness is not the same as acting quickly on a smart idea, so when investors spy an attractive investment option –— and they do emerge — they should be prepared to make a move.

Why? Because in the case of closed-end funds, right now they offer smart but prepared long-term investors the opportunity to buy — on average — a dollar's worth of assets at close to 90 cents. With those assets, investors can enjoy the return potential of less mainstream investment strategies, fully-invested portfolios, and the multiplying effects of leverage — all professionally managed to offer potential for regular cash flow for a long time.

Anne Kritzmire, a Nuveen Investments managing director, leads the firm's closed-end funds and global structured products marketing group.


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