Closed-end funds (CEFs) are complicated, often misunderstood investment mechanisms. When analyzed correctly, CEFs provide the opportunity to quickly diversify portfolios and, in addition, reap tremendous income and potentially capital value. On the other hand, when examined superficially and purchased recklessly, CEFs can turn out to be underperforming, disappointing investments. Savvy investors can benefit from investigating this under appreciated group.
CEFs, in general, possess high distribution rates. Over 80% of closed-end funds provide an annual distribution rate of over 5% calculated at market value. Over 90% provide a better than 3% annual distribution return. I typically view CEF ownership as a total return play, in other words an attempt to garner both above average combined capital growth and income.
The Good and the Bad
So why consider a CEF? There are several reasons in my view:
- Professional diversification to market sectors that retail investors cannot adequately access, research or their own, or have a discomfort in "going it alone" with.
- Ability to purchase assets at a discount to market value. CEFs are valued both on a market and, similar to an open-end fund, on a net asset value (NAV) basis. When the open market value is below the NAV, the CEF is said to be trading at a discount. When the opposite occurs the CEF is said to be trading at a premium. If the discount spread narrows, investors can reap capital gain simply by holding the CEF.
- Unlike a traditional, open-end mutual fund, CEFs have a set amount of shares available for purchase. Management does not need to deal or focus on cash inflows or outflows, and thus can solely focus on management of the portfolio.
On the flip side, here are some reasons to be cautious investing in CEFs:
- High Fees. While many CEFs offer investment fees well below 1%, others charge over 2% for their services. This is something investors should consider when researching the CEF universe.
- Deceptive distributions. Many CEFs will include in an income distribution a return of capital (ROC) component. If a CEF is including ROC in its income distributions, it may not be generating enough organic income to support the distribution. While not necessarily a reason to avoid a fund, investors should understand ROC and its impact before making an investment. If a distribution seems too good to be true, it may turn out to be.
- Lack of liquidity. Some CEFs trade with low assets under management (AUM). If you build a position then are forced to get out, you may not be sell your shares quickly.
Leverage: The CEF Wildcard
- According to CEFconnect.com, a web site that I recommend for analyzing CEFs, nearly 2/3 of all closed-end funds utilize operational leverage. Leverage, in its simplest terms is borrowing by the CEF. This leverage is an attempt by the fund to boost or improve shareholder returns by borrowing at lower short-term rates and successfully employing portfolio strategies.
CEF leverage is a double-edged sword. Shareholders can reap both capital and income benefits when fund strategies work and potentially accelerate losses when they fail. Leverage can range anywhere between 5 and 40%. The higher the leverage, in general, the higher the risk and the reward. Again, leverage is something that should be thoroughly understood before making a purchase.
What to specifically look for in a CEF
In general, I think value in the CEF space can be had by focusing on some of the following screens and investment rationale:
- Historically deep discounts to net asset value.
- Reasonable management fees.
- Equity or income sectors you are unable to adequately diversify yourself in or possess little or no individual expertise in.
- Distributions that appear covered by organic income generation.
- A level of leverage that you are comfortable investing with.
- Average daily trading volume that provides for timely disposition of shares following position build.
What I own, and why
- On AWF, this is a 8% yielding fund that I've held for years that exposes me to global corporate high yield and sovereign debt. While currently trading at a mild NAV premium, the fund has traded at a substantial discount at times over the past several years, and that's when I've added to my position. I find the 1% mgmt. fee reasonable and the 10% leverage quite tolerable. I don't think I'd be buying here, but instead would wait for a discount to reappear.
- I bought JMF last year. This fund exposes me to the complex world of master limited partnerships and energy pipeline companies. Tax reporting for MLPs outside a qualified account can be somewhat time consuming and problematic. I chose to expose to myself to this space through JMF, which simplifies tax reporting. I find the roughly 1.4% mgmt. fee and the 28% leverage on the high side for my liking, but am rewarded with a better than 7% yield and exposure to many of the more attractive names in the MLP space, including KMP,PAA,ETP, and BPL, which the fund includes in its top ten holdings.
- A recent purchase for me is AWP. While the Alpine funds hardly possess a stellar reputation, I think this fund has a lot of things going for it. First, as of May 10, the fund was trading at a 10.5% discount. With a yield in the neighborhood of 9.5%, and minimal leverage in the 5% range, I feel I'm getting a lot of bang for my buck. Alpine recently announced a share buyback, which should help narrow the discount. The fund exposes me to both domestic and international REITs. While I own some domestic REITs, I have no expertise on the international front and am willing to pay a reasonable fee to have someone manage those monies for me. AWP invests in familiar domestic names like SPG, AGNC, and NLY, but also REITs in Turkey, Russia, and Hong Kong. I consider this a solid REIT CEF and an immediate worthwhile purchase.
To recap, the CEF space, while complex, offers diversification and value opportunities for growth and income investors. Individuals willing to educate themselves and engage in thoughtful screening of the group, can find immediate investment values and opportunities here.