The Best of Both Worlds: Unlocking Closed-End Funds Through ETFs

But what if investors didn’t have to choose?  

ETFs of CEFs do exist and offer the best of both worlds. Offering the high yields of CEFs, intraday tradability, and wide diversification benefits, these funds could be a real win for income seekers and investors.  

Despite predating mutual funds by decades, investor adoption of CEFs has been flat to lower over the last decade or so. That’s mostly due to the fact the fund vehicle can be a little hard to understand at first. 

CEFs are issued in a fixed number of shares at an IPO. The proceeds are then used by managers to buy various assets according to their mandate. However, unlike mutual funds or ETFs, there is no creation of additional shares with CEFs. To buy them, their shares trade on the major exchanges. Their share prices are dictated by supply and demand. So, this fact can cause them to trade at discounts or premiums to their net asset values (NAVs). For many investors, this discount or premium to their NAVs can be the first daunting step in using them effectively in a portfolio. 

The second reason for avoidance tends to be their use of leverage. CEFs can use leverage via preferred share issuance or short-term debt. In fact, more than 70% of CEFs employ some kind of leverage. This is particularly advantageous, as many CEF managers focus on the long end of the bond curve. This allows them to juice their assets and returns.

Then there are costs to consider. CEFs tend to have higher expense ratios—at least on the surface—than many other fund vehicles. Thanks to the fee wars and index funds, investors tend to gravitate to the lowest cost options when it comes to building a portfolio. With headline costs in the 0.85% to 2% range, CEFs lose out to ETFs and mutual funds. 

With these reasons in tow, many investors and advisors fail to see the benefits of CEFs including their high yields, the ability to own private and illiquid assets, and potential tax benefits of distributions. They are simply bypassed for other ‘simpler’ fund vehicles. 

Conversely, investors have continued to embrace exchange traded funds (ETFs) with gusto. And one of the major reasons for investor and advisor love is that ETFs have democratized and broken down the barriers for many esoteric asset classes. 

This includes the often-ignored world of CEFs. 

While a small part of the ETF market, there is a vibrant number of ETFs that hold individual CEFs. The win is there are several benefits for investors in combining the two structures. 

The obvious one is diversification benefits. It can be a big task for investors to cobble together a portfolio of different CEFs, covering different segments of the marketplace. But with an ETF, that job is easy and comes with one-ticker access. This also allows investors to diversify across different managers as well. All of this boosts non-correlated returns and smooths out the ride of owning CEFs. 

Second, there’s liquidity to consider, both in terms of assets within the CEFs and CEF shares themselves. ETFs add an extra layer of liquidity to the equation. 

Thanks to their fixed number of shares, CEFs can and do own some illiquid assets. This can include various municipal bonds, leverage loans, asset-backed securities, and increasingly private credit and equity. By placing a CEF into an ETF, you get some extra liquidity for these assets. That comes down to ETF structure. 

ETFs have a dual layer of liquidity designed into them. Authorized participants (APs) create and redeem ETF shares on the primary market by placing the securities into creation units and then onto the secondary market. This secondary market is where the vast bulk of us play. When you want to purchase or sell an ETF, it’s done on a major exchange. These secondary market buys/sells have no effect on the underlying assets, which is great for the illiquidity of what CEFs hold. 

Additionally, CEF trading volumes can vary greatly. Some municipal CEFs feature very low trading volumes and wide bid/ask spreads. By using a very liquid ETF, investors can have fair pricing as market makers work hard to keep prices as close to its NAV as possible. 

Finally, there’s income to consider. 

One of the hallmarks of CEFs remains their ability to generate high income for their shareholders. Thanks to leverage and the potential to trade at discounts to NAVs, they often yield much more than a comparable ETF or mutual fund. This chart from BlackRock highlights the extra yield available from CEFs in various asset classes.

Source: BlackRock

But because many investors don’t follow or use CEFs, they are leaving this extra income on the table. By choosing an ETF of CEFs, investors are able to boost the overall yield of their portfolio within a familiar wrapper. 

Given that CEFs can provide high yields and access to illiquid assets, they do make sense for many portfolios. And by using an ETF, all of those are enhanced.

The best way to incorporate an ETF of CEFs is to think of it as both an equity and bond position. Over time, the number of equity CEFs has grown, while the number of bond-focused CEFs has shrunk. Today, it’s about 50/50 in terms of funds. To that end, it may make sense to reduce a little equity and bond exposure to make room for an ETF of CEFs these days. 

Also, a word about expense ratios. Thanks to quirks with SEC reporting, expense ratios for many CEF ETFs look very high. However, that expense ratio includes the embedded cost of leverage in the funds. You’re technically not paying that in annual operating expenses for the fund. This is the same phenomenon that happens with many business development company (BDC) ETFs. 

These funds were selected based on their exposure to CEFs. They are sorted by their YTD total return, which ranges from 3.7% to 4.7%. They have expense ratios between 1.98% to 5.81% due to acquired fund fees, which is a quirk of CEF ETFs, and assets under management between $40M to $827M. They are yielding between 6.3% and 12.1%.

In the end, CEFs offer plenty of benefits for portfolios. But the weirdness of the asset class makes many investors nervous. ETFs allow investors to tap those benefits with ease and familiarity. By using one of these ETFs of CEFs, investors can get all the benefits and then some.

Closed-end funds are often ignored by investors. But like many asset classes, exchange traded funds have helped solve that problem. By using an ETF, investors can get the best of both worlds into their portfolios.