Closed-end funds can offer opportunities, but they come with risks

Closed-end funds have stood the test of time — for more than a century — and have the potential to help savvy investors. Perceived primarily as income engines, they can offer portfolio diversification. They can also provide higher returns than open-end mutual funds over long market cycles.

Yet closed-end funds (CEFs) are not nearly as popular as open-end mutual funds. Perhaps they should be.
The industry offers more than 580 CEFs with assets exceeding $290 billion, according to the Investment Company Institute. For financial advisers not as familiar with them, I suggest taking a look — for the simple reason that we usually see CEFs in client portfolios managed by advisers with the largest books of business.

That can’t be entirely coincidental, can it?

How CEFs can fit in a client portfolio

• Who: Clients looking for income strategies with longer investment time horizons.
• Why: Closed-end funds can produce higher income than open-end mutual funds.
• How: Structure has ability to buy illiquid assets with higher income potential, use of leverage, with no redemption need and no cash drag.

(More: Old vehicle for income is new again)

What can make closed-end funds appealing?

• High potential distributions: Because their structure allows them to go into less liquid asset classes (and to employ leverage), which carry more risk but can generate higher investment gains, many CEFs can produce income — in the form of distributions — that exceeds open-end mutual fund levels.
• Access to experienced managers: CEFs give clients access to some of the industry’s most experienced, successful portfolio managers. Most also manage open-end mutual funds, so CEFs are not the only way to access their strategies, but they can be a good route.
• Structure: Since they are fully invested, they do not depend on inflows — nor must they pay out redemptions. Managers of CEFs thus can pursue long-term strategies with conviction, holding course in times of turmoil and redeploying assets to invest opportunistically. Leverage also can help magnify gains.
• Exchange-traded liquidity: With no upfront sales charges, CEFs are easy to buy and sell — like most stocks. Investors can use limit orders to buy or sell when pricing moves to their liking. They can be purchased through public exchanges, thus are not limited by a specific platform.

What are the trade-offs?

• Higher volatility: Compared with open-end products, the ability of CEFs to use leverage can increase volatility. CEF strategies often focus on less liquid asset classes and markets that are not as familiar to retail investors. Being publicly-traded, shares of the funds are also subject to market swings.
• Risk: Any product that seeks results — in income, capital appreciation, or both — will by its nature be riskier than U.S. Treasury bonds or other safe havens. The use of leverage can magnify downside returns.
• Trade below net asset value: It is possible many CEFs will trade at a discount at some point. This amount varies and can add to volatility, which is why longer-time horizon investors are best suited to use them.

The vast majority of returns generated by CEFs have come from income. This is paid as distributions from the fund, usually monthly or quarterly. Many CEFs have generated distributions at the high ends of fixed income expectations.

According to the ICI, the industry split is roughly: 30% municipal bonds, 29% taxable fixed-income securities, and 41% equities. Equity CEFs usually focus on specific asset classes, sectors, countries or regions — many are not large-cap products. Allocations to CEFs vary.

Structures and potential advantages

Closed-end funds begin their life cycles by issuing a fixed number of shares through an IPO. Thereafter, those shares trade on an exchange. This creates a permanent asset base, which allows portfolio managers to focus on meeting the fund’s targets rather than attracting more inflows. It has the corollary effect of eliminating outflows.

This has advantages when markets decline: clients may sell their shares, but portfolio managers do not face redemptions. They can stay the course, holding onto desirable positions (rather than being forced to sell at losses) until the market recovers, or using assets to reposition intelligently.

CEFs give portfolio managers greater access to less liquid markets, since under regulatory requirements, open-end mutual funds can invest only 15% of their portfolios in “illiquid” securities. Closed-end funds do not have this restriction, making them compelling vehicles to invest in asset classes such as master limited partnerships and real estate investment trusts.

In addition, many CEFs may use leverage, up to 33.33% under SEC regulations. This gives portfolio managers flexibility to borrow at low rates and invest in higher-yielding assets. When successful, this can bring robust returns — but be warned, leverage can also magnify losses and increase volatility.

Values rise and fall

Prices of CEFs may trade higher or lower than the fund’s NAV. When the trading price goes above NAV, the fund is said to be at a premium; below NAV, at a discount. Supply and demand determines share value, but market prices trade relative to their NAVs: over the past 15 years, the discount has averaged about 4%, according to Morningstar Inc., but variations of plus-10% and minus-15% have occurred. Over the long-term, share prices of closed-end funds can track their NAVs.

[More: Closed-end funds for retirement income: Why anxious retirees should consider closed-end funds]

Although there are no required minimums, closed-end funds are not for every investor. This can be a retail product for those who can stomach the associated risks in their search for relatively high-potential income and gains.

Closed-end funds can offer advisers opportunities to introduce clients to successful portfolio managers and strategies at a discount, when prices fall. Thus, for savvy advisers, understanding the value of closed-end funds can serve clients’ interests well.

Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.