Why Closed-End Funds Don't Work for Most Investors

Roger Nusbaum submits: Barron's has an interview with Thomas Herzfeld, who is all things closed end funds.

The interview gives an inkling of how complex investing in CEFs can be when he says they look at 20-30 different things to pick funds.

I went to the Herzfeld website and found a link to a free back-issue of their regular reports that your can subscribe to. There was a ton of information in the free back-issue.

Included in there toward the end were several portfolios with different objectives, including a U.S. Equities Portfolio. A couple of observations:

The portfolio had 14 different funds. I was surprised that in looking at them on ETFconnect, there is very little overlap of holdings within the funds. There is some, but not a lot. This is not easy to do.

Consistent with the article, almost all of the funds were trading at big discounts to NAV. Some of the funds have almost no volume. Of the 12 holdings that Yahoo could chart (there were two it could not), nine lagged the S&P 500, two beat and one had the same return.

I concede that in most instances the S&P 500 is not the best benchmark for this study, as some of the funds are smaller in cap size. This lag of the funds means one of two things: either this portfolio lagged badly (not the bet I would make), or they do a lot of trading and get good returns (this would be the way I would lean, but I did not see any returns posted, apologies if I missed). For the month of April, this portfolio had eight trades -- which seems active to me. It would be very difficult for most do-it-yourselfers to replicate this on their own.

This is his approach, and I am sure it is successful for him, but either you pay them to manage your money, try to do re-create something similar yourself -- or use closed end funds in a completely different manner. It that last one that I have gravitated to.

For certain segments of the market I think closed end funds work very well, but I am not sure plain, domestic equity exposure is one of those segments. I have one call-writing CEF as an across the board holding. Some clients own one of the India CEFs. A couple of clients own a dividend capture fund, and that is it on the equity side of the ledger. I do a little more with fixed income CEFs with a convertible bond fund, a foreign bond fund, and in some instances a generic bond fund.

Herzfeld has forgotten more about CEFs than I'll ever know -- so he can use all-CEF portfolios. Most us should not, including me.

Comments

[John Gaats:]

Has anyone tested the profitablity of a contraian investment with CEFs. Are CEFs always traded below NAVs?

2007 Jul 09 10:54 AM

[Roger Nusbaum:]

I don't know if anyone has tested that or not.

CEFs seem to usually trade at a discount but this is a generalization. For example where was a period where just about all the call writing CEFs were at a premium.

The way I tend to view it is what is normal for that fund.

2007 Jul 09 12:24 PM

[huangjin:]

In one of my finance textbooks it said there is a pretty clear way to profit by buying CEFs at deep discounts. I assume the only time this fails to work is near market peaks.

2007 Jul 09 02:11 PM

[JonD:]

i agree, Roger. there are much more efficient ways to invest in mainstream markets (such as domestic equity) but CEFs are great for niche asset sectors that may not be large enough to support an OEF. and CEFs typically utilize a bit of leverage which, when used in moderation, can give them an edge over ETFs. the downside is the NAV discounts (or premia) depending on whether you are a buyer or a seller and the relatively high management fees.

i personally own the following

JRO (from Nuveen) --- floating rate fixed income
JPS (also Nuveen) --- diversified preferred equity
TYG (from Tortoise) --- collection of pipeline MLPs
MGU (from Macquarie) --- collection of publicly traded global infrastructure assets

also, as you mention, muni bond and foreign bond CEFs are attractive as well.

2007 Jul 09 08:28 PM

[Elliott:]

With all due respect I think you really missed the boat on this one. Just because T. Herzfeld uncovers complexity in CEFs that means that you make a sweeping generalization that CEFs are not appropriate for most investors?

A Univ of Texas research paper concluded that "closed-end fund returns are both more predictable and more positively skewed than those of the returns from the corresponding net asset value." This makes sense to me. Which is better to buy: a basket of utility stocks or a CEF holding the same stocks but sells for 10 percent off? I'll take the CEF because the discount means less downside risk.

2007 Jul 10 01:07 AM

[Roger Nusbaum:]

James, I believe the title of this post, which was chosen by the Seeking Alpha Editors, skewed where you thought I was coming from. I originally posted this on my blog with the title "Sunday Morning Coffee" which is how I title every Sunday morning post.

My conclusion was about <em>all-CEF-port... not as general as you note, although again I think the title did a disservice. After all I do use them as outlined above.

To be clear I am not a fan of all-anything portfolios.

As for you comment about utilities; do you know of a utilities CEF that has a track record of outperforming the sector. I'm not being a wise guy, I don't know of one and would be interested. Thank you.

2007 Jul 10 09:01 AM

[Roger Knouse:]

UTF
closed-endfunds.com/Fu...

2007 Jul 10 11:21 AM

[Elliott:]

Roger: How about GUT -- Gabelli Utility Trust -- it has outperformed the utility index and the SP500 over the last 5 years.

quicktake.morningstar....;Symbol=GUT&amp;fd...

It trades at a premium to NAV, but you might never get a chance to buy it at a discount. Probably due to its high yield. Speaking of yield, how do they pull off an 8% yield when utility stocks pay 4%?

2007 Jul 11 02:11 AM

[Roger Nusbaum:]

I have looked at this one before. The discount appears to be getting just a tad wider as time goes on but maybe I am not seeing that correctly as I eyeball the ETFconnect chart. Either way the discount has persisted.

I compared it on a chart to XLU and IDU. It lags for five years and two years. It clearly beats for one year and beats by an imperceptible amount for YTD and six months.

The link you left says the fund is 33% leveraged which could be dicey if rates in the middle of the curve go higher.

2007 Jul 10 01:02 PM

[Roger Nusbaum:]

GUT has the yield from leverage (20% a/o year end) also I wonder about return of capital too. I didn't look that up though.

Further did you look at it on a chart? I looked for one year only and both the market price and the NAV lagged XLU and IDU by noticeable amount. Once you factor in the distortion for the dividend. I didn;t look at any other time periods.

2007 Jul 11 06:13 PM

[marionm112:]

GUT has periodically offered stock as a rights offering.

2007 Jul 30 01:06 PM

[User 239889:]

This is great news!

2008 Aug 13 07:14 AM

[doright:]

And more rot. Depending on the size of the management fee, you will be paying back some of that discount every year.
Also, some cef managers are motivated by their gain rather than total return for investors. They tend to trade at seemingly large discounts and those discounts are warranted.


On Jul 10 01:07 AM Elliott wrote:

> With all due respect I think you really missed the boat on this one.
> Just because T. Herzfeld uncovers complexity in CEFs that means that
> you make a sweeping generalization that CEFs are not appropriate
> for most investors?
>
> A Univ of Texas research paper concluded that "closed-end fund returns
> are both more predictable and more positively skewed than those of
> the returns from the corresponding net asset value." This makes sense
> to me. Which is better to buy: a basket of utility stocks or a CEF
> holding the same stocks but sells for 10 percent off? I'll take the
> CEF because the discount means less downside risk.

Mar 04 06:52 PM