I recently conducted "virtual interviews" with some of Seeking Alpha's Closed-End Fund experts and contributing authors on the subject of CEF investing. Although we did not explore these assets in-depth, I believe the responses as a whole will benefit our readers by touching on some of the nuances involved with closed-end funds.
Each author was asked to spend just a few minutes answering the following questions:
- Do you use closed-end funds for growth or for income?
- Based on your personal experience, what has been the biggest benefit that investing in CEFs has provided?
- Based on your experience, what has been the biggest drawback?
- If you had to explain to an acquaintance in just two or three sentences why you invest in CEFs, what would you say (i.e. what would be your "30-second commercial" for CEF investing?)?
So let's dive right in. (Please note that some responses have been edited for clarity and/or brevity).
Nick Ackerman is a newcomer to Seeking Alpha but has quickly risen to the most recent Top Ten authors on Closed-End Funds in a short period of time. He responded as follows:
1. I would say I use CEFs for both growth and income. My strategy is to collect the income to purchase more CEFs that grow my total distributions from the funds I hold. My goal is to continually increase my income and keep reinvesting them to "grow" my portfolio and not spend the actual distributions. I essentially DRIP, but instead of going back into the same fund, I try to choose which would be the best use of capital at that given time.
2. The monthly paying CEFs are what I would consider the biggest benefit, at least for myself. I enjoy getting the monthly income to reinvest into more income. Compounding faster monthly, rather than quarterly, I believe is a good strategy.
3. I would say the biggest drawbacks are the funds that can trade at perpetual discounts that can exist when you know a fund is solid but it just can't catch traction, or funds that trade at premiums when you want to purchase them but they remain overvalued...hardest decision is to purchase a fund at a premium, in my opinion.
4. 30-second commercial for CEF investing: "Welcome to the world where price isn't always rational and you can purchase funds on sale! A world where outsized distributions are the norm!"
George Spritzer, CFA is a registered investment advisor specializing in managing closed-end funds for individual clients. He gets straight to the point:
1. I am primarily a total return investor. In tax-deferred accounts, growth and income are both good. In taxable accounts, I prefer growth or tax "friendly" income.
2. CEFs provide a good way to buy diversified assets at a discount.
3. The biggest drawback is low liquidity of many issues.
4. The main advantage of CEF investing is buying assets at a discount, but there are also good opportunities resulting from rights offerings, tender offers, etc. Because the asset type as a whole is small, there is also less competition in closed-end funds.
Steven Bavaria is known on Seeking Alpha for his "Income Factory" approach to investing and for his book Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism about excessive CEO pay.
1. I use closed-end funds extensively for both growth and income. But I achieve the growth in my portfolio through reinvesting and compounding at high yields. Unlike typical "dividend growth investing," which buys low-yielding stocks or funds and looks to future growth in the dividend as their source of portfolio growth, my "Income Factory" strategy creates its own growth through compounding. In this way, my income grows through all kinds of markets - flat, up or down - and in fact my income growth accelerates during down markets because I am reinvesting at bargain prices and higher than normal yields. Closed-end funds are perfect vehicles for doing this.
2. The biggest benefit of closed-end fund investing is professional management of diversified portfolios of often complex and somewhat illiquid asset classes. These are not assets you would want to hold in "open-end" mutual funds where you are at the mercy of panicky investors demanding share redemption at the most inopportune times, forcing managers to sell out healthy assets just because their prices are down. This is why many closed-end funds are able to keep their heads down and just keep churning out the income like the Energizer Bunny, even when markets are highly volatile.
3. I don't see any disadvantages, other than that the market is quirky and unpredictable, which some may see as a disadvantage, but many of us see as a positive feature that allows us to buy quality assets when they are inexplicably down for reasons having nothing to do with the underlying soundness of the fund itself.
4. In my 30-second "elevator speech," I would emphasize the closed-end structure mentioned above and the protection it gives to long-term investors against "runs on the fund," along with the advantage of buying at discounts to net asset value so you have more assets working for you than you actually had to pay for. That adds enormously to your yield pick-up over the years. You also get the benefit of cheap institutional leverage, so your fund can borrow at a low rate, reinvest in assets paying much higher rates, and then pay investors the spread and thus create the high yield.
1. I use CEFs for both growth and income. While CEFs are well known for income, there are some funds where reinvested dividends provide tremendous compounded total returns that beat the S&P 500 and even some growth index funds. However, income is definitely my primary focus when it comes to CEFs, namely finding and securing 7% or higher sustainable dividend yields and a diversified portfolio.
2. CEFs provide exposure to several asset classes, an opportunity to buy assets at a large discount, and a high income stream. Personally, CEFs were tremendously helpful for me in gaining financial independence at a relatively young age - their high income stream made it possible for me to quit a job I did not like and pursue other interests.
3. CEFs can and will cut dividends; this is a fact of life investors need to accept. Often, these dividend cuts are the result of management policy and therefore difficult to time. Sometimes, the dividend cuts are a sign that the fund is being prudently managed and can thus be a strength and not a weakness of the fund. Investors need to create a plan so that these dividend cuts do not negatively affect their income stream.
4. CEFs provide a high passive income stream that gives investors greater control over their assets than index funds, while also providing exposure to a variety of assets beyond the stock market such as municipal bonds, corporate bonds, and preferred stocks. Plus, there are many CEFs that have beaten the S&P 500 over a long time frame, and many more with the potential to do so in the future, which makes them worth investors' attention.
1. We use CEFs primarily for income but a second consideration is some capital gains (growth) from buying opportunistically.
2. The biggest advantage is the ability to meet retiree income needs in today's ultra-low interest rate environment. Retirees today are being punished by the low rates typically available, which creates a perverse incentive to reach for yield by assuming significantly more risk. We have seen investors increase their risk appetite substantially in order to meet their return hurdles. This is likely going to come back to haunt many investors as risk tolerances and portfolios are not aligned.
3. The biggest disadvantages are liquidity and distribution cuts. Most of the compelling funds are small with only a small number of shares traded each day. This makes them un-investable for most of our members who tend to have larger portfolios and want to be nimble enough to get out of them.
Distribution cuts have also been a significant drawback for investors. Cuts have been pervasive since 2008, given that the higher coupon bonds prior to the recession have all been called or matured. They have been replaced by lower coupon bonds, forcing cuts. Today, we are also dealing with higher leverage costs as the Fed raises short-term rates. However, we do think we are closer to the end of this process than the start. Perhaps in two years, as rates rise and old bonds have all been expunged, the weighted average coupon in the market will be greater than in the funds.
4. Closed-end funds are far-superior structures than mutual funds, especially on the bond sides since they do not have daily cash flows. They allow retail investors to gain access to institutional cost of financing to generate substantially superior yields. They are perfect vehicles for today's low interest rate environment.
Arbitrage Trader is a day trader, trading any preferred stock or closed-end fund that provides an arbitrage opportunity. He offers a different perspective on investing in closed-end funds from that of the others.
1. I use CEFs mainly for pair trading and as substitutes for ETFs when CEFs become undervalued.
2. The biggest advantage of CEFs is that they deviate from fair value which can bring you Alpha both on the downside (buying an undervalued one) and on the upside (boosting your return by selling an overvalued CEF).
3. The biggest drawback in CEFs is that management will always screw long-term holders by all kinds of offerings including rights offerings. This is their way to boost their paycheck while taking value from the average long-term investor. They will use every possibility to "manage" more assets. In addition, some CEFs overpay their actual returns and create demand from dividend yield hunters. It works like a Ponzi scheme and when the dividend yield cannot be maintained, the long-term holder takes all the pain. Sometimes CEFs fall drastically on dividend cut news. There is no way to stand up after such a knock down. Another very nasty disadvantage is that people sometimes think that there is some exceptional stock-picking skill in management teams and are ready to overpay for it, while in fact most CEFs are as passive as any other ETF. And one should not forget about the crazy management fees for doing almost nothing.
4. The only reason I look at CEFs is because they provide some of the easiest-to-track mispricings. I don't see any real benefits for the long-term investor in general. With very limited knowledge, one can duplicate any CEF performance at a lower price.
Maks F. S. is a financial planner and editor of Income Idea, a premium service geared toward discovering and implementing actionable ideas and strategies and focused on generating income in all market environments.
1. We use CEFs for both growth and income. Investors need to keep in mind that a closed-end fund is merely an investment structure, not a unique asset class. However, it just so happens that CEFs are predominantly fixed-income oriented funds and sell themselves on a distribution. As such, they have become associated as income vehicles but, in reality, they can be either/or. For instance, there are plenty of equity focused CEFs which do not pay a regular distribution.
2. A big benefit of CEFs is that, due to the imperfect marketplace, you are often able to generate additional alpha by buying quality CEFs at a significant discount to NAV and are then able to sell it above NAV when the marketplace is foolish enough to overpay.
3. The biggest drawback for investors is the additional volatility. One big reason for the volatility is that many of the fund managers use leverage within the fund. As such, returns and losses are magnified. The biggest drawback of the structure itself, however, is the discount between the market price and net asset value. For most investors, this is tough to swallow, knowing that the portfolio did its job, but because the market does not find the asset class or fund in favor, the fund gets sold off.
4. CEFs have unique features which can offer investors an opportunity to create both above-market distributions and overall returns. They do, however, demand great respect and require significantly more time to understand and stay up-to-date on. For all of the great benefits there are outsized risks and investors need to read the statements, understand where the distribution is generated and the risks of leverage. In CEFs, investors NEED to understand exactly how they work. If you cannot do that yourself, you need to find someone who does if you want to play in this space. Not doing so only causes great grief when the fund sells off and investors are left wondering "Why?"
John Cole Scott is Chief Investment Officer at CEF Advisors which sells closed-end fund data & news subscriptions, model portfolios, managed accounts and consulting projects. (See cefdata.com/portfoliocomp).
1. We run 14 different CEF/BDC models based on our CEF Trifecta analysis balancing Discount Direction, Dividend Direction & NAV Direction. Income is always a significant component. I find we are usually optimizing clients' need for income in their accounts based on adjusting their portfolio for Beta risk, Duration risk, Dividend risk, Discount risk, Tax friction, and Correlation risk. We also have capital appreciation-focused CEF strategies and very low beta, market-neutral CEF Long/Short fund strategies where prudent for investors.
2. A big advantage of CEFs is accessing a fixed capital portfolio with the ability to buy access to bonds purchased in the past. With cheap leverage and the inefficiencies in trading from retail investors and even many financial advisors, we get to add a contrarian lens and seek to outperform from improving NAV returns and narrowing discounts. It is not uncommon for a diversified portfolio of 30-40 CEFs/BDCs to have average peak-to-valley discounts of 15% to 20% over the past 3 years. This is an easy way we show that discounts change over time.
3. There are some key drawbacks or risks I think every CEF/BDC investor needs to understand to avoid poor decisions and analysis. The main drawbacks we see are: 1) when discounts widen dramatically, it often scares investors into panic selling at the wrong time. They don't look at how a fund's actual value (its NAV) performs on a bad market day, week, or month. 2) Investors don't look at ex-dividend dates to know when they are pending a large amount of distributions. Instead, they get panicky when they see their accounts pull back on the ex-div date and dismiss the fact that they are earning about 7.5% to 9% a year through the distributions. 3) Dividend "Policies" are not promises and can be changed by any board of directors by a simple press release. In the past two years, 2/3 of funds changed their dividend amounts (increases and decreases). The sector requires an amount of patience, diligence, and sometimes "going against your gut" to do well, in our experience.
4. Through CEFs/BDCs, we have diversified, multi-manager, liquid access to above-normal income generally provided by cheap leverage and discounts. Most CEFs pay 1.5% to 3% more to shareholders than the managers need to earn to fuel the dividend policy. We can seek "expensive" exit points and "cheap" entry points due to one of the last places that markets are regularly inefficient. It is hard to be a large Hedge Fund and do well in this space due to liquidity and nuance, so it is a great place for small and medium investors that focus and pay attention.
1. We use CEFs primarily for income, but also enjoy growing the income stream through distribution reinvestment as well as rotating between overvalued and undervalued CEFs.
2. The biggest benefit in our experience is the ability to exploit CEF premiums and discounts in order to juice returns in a CEF income portfolio. I've written extensively about this in my public articles and interested readers can feel free to check them out.
3. The biggest drawback is that falling premium/discount values can exacerbate price declines in falling markets, which could place psychological pressure on less experienced CEF investors to sell at the most inopportune times.
4. Closed-end funds provide steady income, diversification, active management and institutional leverage all rolled up into a single wrapper. Selecting the right CEF, and at the right price, dictates performance to a large degree. To that extent, we have been quite successful in using a quantitative approach to address both of those parameters.
And, just for kicks, my own two cents:
1. I use closed-end funds to compound a portfolio that will provide future income aimed to last into perpetuity.
2. In my experience, the biggest advantage to CEF investing is the ability to stick to my strategy no matter what happens in the markets. Reinvesting distributions and rebalancing positions has made my CEF portfolio progressively less risky and more efficient by taking advantage of their well-known pricing anomalies, opportunistic yields, and even market trends. With this mindset, market corrections no longer scare me, but instead provide the opportunity to kick the compounding machine up a notch while still pumping out income. I believe that CEFs are widely misunderstood investments, and that concerns about the various risks of closed-end funds can be mitigated through the investor's system of portfolio management.
3. The biggest drawback I find with CEF investing is my own difficulty in correctly interpreting NAV downtrends. It can be difficult to tell if the fund is following the market cycles of its underlying holdings or if the value of the fund is actually eroding.
4. Closed-end funds provide a simple way to diversify, generate income, and compound your money. The fund structure keeps the funds rolling during a market panic, allowing investors to continue to get paid while waiting out the turmoil. CEFs provide a way to create our own "annuity" that can potentially provide a steady stream of income without the need to deplete shares to meet expenses in retirement.
What I appreciated most about this exercise is that it highlighted how investors with different objectives view the various aspects of closed-end funds differently, sometimes even in direct opposition to one another. I would have liked to have heard from more Growth and Total Return authors to get an even better understanding of their perspective. It came as no surprise, however, that those who use CEFs as shorter-term trading vehicles tend to dislike the very traits that long-term income investors love. This just goes to show that investors must fully understand what their own investment objectives are before adopting any investment strategy.
Thank you to everyone who participated in this survey. I hope our readers have found some benefit in reading it.
Be sure to check out these authors' writings and resources.
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Disclaimer: Nothing in this material should be taken as a recommendation or financial advice. Your situation will be different from those of the contributors to this article. Please do plenty of due diligence before embarking on any investment strategy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.