By Jonathan Diorio
Even after a year that saw major stock market indexes simply tread water, equities are by many accounts considered expensive, challenged by rising interest rates and a less-than-stellar outlook for corporate earnings. But there is one underutilized corner of the market that, for some investors, may be worth a peek: closed-end funds (CEFs).
CEFs remain one of the more misunderstood products available to investors, but the virtues of these vehicles are numerous, and it's worth getting to know some of the potential advantages.
First, the basics. CEFs have a fixed number of shares outstanding and do not issue or redeem shares to meet investor demand. The funds typically trade on a major stock exchange and the market price of the shares fluctuates, generally determined by supply and demand. So, they are similar to mutual funds in that they are actively managed, but they trade daily like an exchange traded fund (ETF). Since they do not need to manage inflows and outflows of assets, CEFs can generally remain fully invested at all times. It's important to note that CEFs can experience sudden intraday drops, which could cause investors to sell suddenly.
This efficient management is one unique attribute of CEFs, as open-end funds have to manage continuous cash flows. In other words, when a shareholder of an open-end fund decides to sell shares of the fund, the mutual fund will redeem shares at net asset value (NYSE:NAV).
Investing for income
A key feature of the CEF structure is the potential for a higher income stream. This dynamic, achieved by using certain strategies, primarily leverage, may be particularly compelling to investors looking for income in the current low-rate environment. Most CEFs distribute income on a monthly or quarterly basis, and investors have the option of receiving distributions in cash or having their dividends reinvested. By automatically reinvesting dividends, investors purchase additional fund shares on a regular basis, which over time has the potential to lead to higher future returns. Of course, as a result of using leverage, CEFs have the potential to magnify losses.
Some of the strategies employed by CEFs may be appealing to equity investors who are looking for income with potentially less volatility relative to a long-only stock portfolio. Likewise, risk-averse investors hunting for income opportunities may find the uncorrelated nature of some CEF investments attractive. For instance, funds that use covered call strategies often have lower correlation to other asset classes, and over the long term a covered call strategy can help reduce volatility compared to a long-only portfolio. Covered call strategies can also limit the upside of some investments.
Another potential advantage of CEFs comes in the form of a fund's "discount." A CEF may be priced at a discount when its share price is lower than its NAV, or at a premium when it is higher. For example, if the market price of a fund share (the price the market is willing to pay) is $18 and its NAV is $20, it is selling at a $2 (or 10 percent) discount per share. If the market price per share is $21, the fund is selling at a premium of $1 (or 5 percent). In the current market environment, there is no shortage of such funds for investors to consider. Indeed, Bank of America Merrill Lynch recently estimated that 92 percent of all CEFs are trading at a discount, with the average discount hovering at around 9 percent. The firm also noted that for "normal markets," such a steep discount has rarely been seen over the past 20 years.
Because they trade in an open market system, CEFs are subject to the laws of supply and demand; the factors that influence demand are also the factors that will determine whether a fund trades at a premium or discount. These include:
• Current yield on stock price/NAV (relative to other closed-end funds/investment products)
• Current discount/premium
• Dividend cuts/increases
• Fund performance (relative to other closed-end funds/ investment products)
•Performance of the closed-end fund's sector (relative to other closed-end funds/investment products)
• Investor sentiment
• Market outlook
• Sector outlook
• Availability of comparable products
Closed-end funds continue to evolve to accommodate the objectives and risk tolerance of a wide range of investors, and they can play an important role in a diversified investment strategy.
This post originally appeared on the BlackRock Blog.