Seeking Alpha

Income Lab Ideas: Closed-End Funds Vs. Open-End Funds

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Includes: AIVSX, BDJ, CYPIX, DNI, ETG, ETO, ETV, FCNTX, FEQIX, FXAIX, GDV, GWPAX, JRI, KYN, KYN.PF, PHK, RYLDX, TEPIX, USA, UTF, UTG, VCDAX, VFIAX
by: Nick Ackerman
Nick Ackerman
Long only, closed-end funds, dividend growth investing, dividend investing
Summary

CEFs and open-end funds offer investors a pool of diversified holdings.

While there are some similarities, there are also key differences that set these two investments apart.

Typically, CEFs offer investors more exotic options in their underlying holdings and structure.

The more exotic nature of CEFs can expose an investor to more risk, but potentially greater returns.

Co-produced by Stanford Chemist. This publication was originally released on September 29th, 2019.

Closed-end funds and open-end funds offer investors an opportunity to pool assets together and purchase several underlying holdings, helping to mitigate the risk that is presented in individual company stock. Both investment opportunities are also regulated under the Investment Company Act of 1940. This act helped regulate and set standards for both of these organizations. Additionally, with the Securities Act of 1933, provided more transparency and stability to these vehicles. Along with closed and open-ended funds, unit investment trusts [UITs] are also regulated as an investment company and fall under the same rules.

One might be curious to know why exchange-traded funds [ETFs] aren't listed as being one of the main three categories by the SEC. That's simply because an ETF has to register as either an open-end investment company or a UIT. Therefore, an ETF is registered into one of the three main categories and in itself is not classified separately.

Some investors may be curious to also know that closed-end funds were created before open-end funds. Today, there are many more open-end funds compared to closed-end funds. There were actually 9,599 open-end funds in 2018, compared to 506 closed-end funds.

The focus today though is in how closed and open-end funds are similar and different. It is important to note that open-end companies are generally referred to as mutual funds, from here on out, that is how they will be referenced. The common abbreviation for a closed-end fund is CEF and will be referenced as such through the remainder of this writing.

Some Similarities

As referenced above, both investments are a way for an investor to gain exposure to several underlying individual stocks through one investment. This helps mitigate the potential risk that is presented when holding one individual company. Enron anyone? Enron is a bit of an extreme example, but companies do file for bankruptcy. The share price of these unfortunate companies essentially can drop to $0 if traded publicly and leave investors holding the bag. Through utilizing a pooled approach an investor is gaining exposure to multiples - sometimes 100s - of companies that make up the underlying portfolio.

Sometimes the diversification is only through holding multiple companies within the same sector. Sector-specific CEFs and mutual funds exist, for example, Vanguard Consumer Discretionary Fund (VCDAX) and Reaves Utility Income Fund (UTG). These aren't diversified at a broad level but allow for investments among many companies that operate in defined sectors.

Another characteristic of mutual funds and CEFs is that they are professionally managed, for better or worse. This is definitely a source of debate. Since the funds are actively managed they have higher expense ratios compared to their passively managed ETF counterparts too.

The Many Differences

One of the key differences that separate mutual funds and CEFs, is how they are bought and sold. CEFs are traded on exchanges, like the NYSE, throughout the day. Mutual funds are repriced at the end of the day and this is when they are "bought and sold." Essentially, the price per share is calculated based on outstanding shares and the underlying net asset value [NAV].

This brings up another important difference between the two, since CEFs trade throughout the day, they are bid higher and lower by supply and demand. The more buyers of the underlying CEF, generally, the higher the price and vice versa. This is because CEFs are not required to trade at the NAV of the fund. This creates discounts and premiums as the "market" price is not the same as the NAV price.

An important distinction of the supply and demand on CEFs is brought on by the structure of CEFs. CEFs go through IPOs like any other listed company on an exchange. This creates a generally fixed number of shares, hence the "closed" part of their name. Mutual funds, on the other hand, have a creation & redemption mechanism. This means the number of outstanding shares from day to day changes. This is why mutual funds are only bought and sold at their NAV. ETFs have this same mutual fund characteristic and is why they also don't deviate too far from their NAV per share. However, since they also trade throughout the day like CEFs some small discrepancies can emerge. Definitely not on the same level exhibited by CEFs though.

For some extreme examples of discounts and premiums for CEFs, we can turn to the PIMCO High Income Fund (PHK) trading at a 25.45% premium - meaning that shares can be bought for $7.74 but the underlying NAV is $6.17. Generally, not the best idea to buy funds at such extreme valuations because you are essentially buying something for more than it is worth. This isn't the only valuation metric that should be relied upon though. The historical trading range as it relates to the premium/discounts should also be considered. To go on the other end of the spectrum, we can look at the Dividend & Income Fund (DNI) that trades at a 20.20% discount. DNI trades for $11.89, with a NAV price of $14.90, essentially paying almost only $0.80 on the $1. At first glance one may automatically assume that DNI is a better buy, however, its 1-year average discount is 23.25%. This can be compared to PHK's 1-year average premium of 31.64%. Meaning that PHK is actually trading below its average premium and DNI is trading above its average discount!

Chart

Data by YCharts

As referenced above, CEFs are "closed" in that they don't create or redeem new shares daily. However, CEFs can, and often do, have a changing number of outstanding shares though. This is through various actions of the underlying CEF; rights offerings, at-the-market offerings and dividend reinvestment plans. Primarily though, these are not a daily occurrence like mutual funds.

This key difference gives investors a potential opportunity. Through buying shares of CEFs, an investor can possibly successfully trade for added profits. At the CEF/ETF Income Laboratory, we call this "compounding income on steroids." This is because a CEF will generally "revert to the mean," essentially, the CEF will trade towards its historical trading discount/premium. Taking advantage of this pattern can add significant value to an investor's portfolio, beyond just higher-than-usual payouts.

Further setting these investments apart is their use of various other strategies in the underlying portfolio. Typically, a mutual fund is quite plain in its investment approach, holding securities of common or preferred stock and bonds. CEFs on the other hand, commonly use leverage or various options strategies to potentially enhance income, and therefore, total returns.

There are mutual funds that use leverage and options strategies too, it just isn't as typical. Additionally, CEFs can use varying sources of leverage; borrowings, preferred issuances, reverse repurchase agreements and credit default swaps. The most common among these four are borrowings and preferred issuances. Some examples of leverage include Nuveen Real Asset Income & Growth Fund (JRI), the fund has $534.138 million in net assets but total managed assets are $751.863 million through borrowings. A fund that issues preferred shares for leverage is Kayne Anderson MLP/Midstream Investment Company (KYN). KYN has $2,446 million in net assets, but total managed assets of $3,579 million through the issuance of preferred shares - Kayne Anderson MLP Investment Co 3.5% Mandatory Redemption Preferred Shares Series F (KYN.PF).

Again, there are mutual funds that use leverage too, it just isn't as common to see. Those that do are also generally more passive in nature and linked to an index. A few examples are; ProFunds Consumer Services Ultra Sector (CYPIX), Rydex Dow 2x Strategy Fund (RYLDX) and ProFunds Technology Ultra Sector Fund (TEPIX).

The leverage that is used gets added onto as an interest expense in the total expense ratio of funds, this is often a source of confusion. Investors typically see a huge total expense ratio and immediately write the fund off. I do believe that a lower expense ratio is a good thing, however, it needs to be taken in context. To go back to the example of JRI. The expense ratio of the fund is 1.24%. However, when the leverage expense is added to the total, this climbs to 2.17%. The fund pays just over 3% on their borrowings. Anything the fund is able to earn above this 3% is positive for investors as the earnings of the fund is then increased. Of course, this can be a drag to earnings too if they are unable to out-earn the expense of interest.

The most common options strategy utilized by CEFs is through using covered calls on individual positions or through calls written on indexes. BlackRock Enhanced Equity Dividend Trust (BDJ) is an example of a CEF that writes options on individual securities in its portfolio. Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV) is an example of a CEF that uses an index writing option strategy.

Through these differences, CEFs can typically pay out larger distributions. A keyword to note here is that mutual funds will pay dividends and distributions, while CEFs pay distributions. Dividends are from sources of a coupon payment, in the case of bonds, and dividends accumulated from the underlying portfolio. This gives us net investment income [NII]. Distributions, on the other hand, are derived from various sources that include; NII, long or short-term capital gains and return of capital [ROC]. For more on capital gains, you can read our previous "Income Lab Ideas" piece on the tax benefits of capital gains. Mutual funds, if applicable, will pay a distribution or special year-end "dividend" at the end of the year, in most cases on the funds' realized capital gains.

This also contributes to why CEFs can pay higher distributions throughout the year, as CEFs can be set up to pay out stable distributions by utilizing capital gains and ROC throughout the year. Generally, CEFs are favored by income investors and retirees, the stability provides predictability. It doesn't mean that it is guaranteed though, as distributions can be cut at any time. I'll provide a quick example of the stability in payouts with Fidelity Equity Income Fund (FEQIX) and the Gabelli Dividend & Income (GDV).

(Source - Seeking Alpha)

As we can see, the varying amounts paid out by FEQIX may not be a great fit for those on a fixed-income. This doesn't mean it isn't a good investment, just may not be suitable for an income investor. Additionally, you may have noticed GDV pays a monthly distribution. For those that aren't using the income to live off of, this provides a faster rate of compounding, leading to generally greater returns. For those that are living off the income, a monthly payout might be appealing as well. The topic of compounding is another item we have covered in a prior "Income Lab Ideas" piece, "Reinvestment's Huge Role In Your Portfolio." Mutual funds can offer monthly dividends as well, but these are commonly reserved for fixed-income focused mutual funds. In contrast, a large portion of equity-focused CEFs offer monthly distributions. As we previously noted CEFs generally have larger payouts, GDV's distribution rate is 6.13% compared to FEQIX's dividend yield is 1.92%.

Conclusion

In general, mutual funds are perfectly fine investments for passive long-term investors. CEFs can also be a source for passive long-term investors; however, some key features help set these apart. The fact that the funds trade at premiums and discounts can help provide an additional source of profit for an investor. In addition to the premium/discount phenomenon, the fact that CEFs trade throughout the day makes this option viable. Additionally, the use of various forms of leverage and options strategies can help enhance the income potential of the funds. Allowing these to be higher-yielding securities. However, keeping in mind that these added "benefits" also add risk and can increase losses too during times of volatility.

Personally, capitalizing on these added characteristics offered by CEFs makes them a more attractive option for my portfolio.

Disclosure: I am/we are long BDJ, ETV, JRI, KYN, UTG. 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.