The Case for Closed-End Funds: Why This Overlooked Structure Still Shines

Case in point, the humble closed-end fund (CEFs).

As one of the oldest fund vehicles, closed-end funds have unique attributes that make them perfect for certain asset classes and applications. By ignoring them, investors may be doing their portfolios a disservice. With that, here are five reasons why they should consider CEFs.

Many investors believe that mutual funds are the oldest investment vehicle. The truth is that closed-end funds take that title with several still in operation, dating back to the 1850s. Those early funds were companies that, in addition to owning their business assets, started to purchase common stocks. Eventually, the investment portfolios got large enough or the underlying business was closed that they only owned stocks and other investments. For example, the Adams Diversified Equity Fund Inc dates back to 1854 and was formerly a cargo transporter that was part of the Pony Express system.

Today, CEFs are issued by dedicated asset managers under a specific mandate or asset class. It’s here that the fund structure gets its quirks.

CEFs are IPO’d with a fixed number of shares. Hence, the “closed” moniker. Both ETFs and mutual funds can continue to create shares as assets flow into the fund. Managers of CEF then buy assets according to their mandate, and the shares of the fund are subsequently traded on the major exchanges.

Because their values are driven by supply and demand, they can trade at discounts or premiums to their underlying net asset values, allowing investors to possibly get exposure for pennies on the dollar.

So, why bother with closed-end funds? Well, this quirky structure has several benefits for investors across a variety of avenues. In fact, there are five big ones.

For starters, one benefit is that CEFs can use leverage via preferred share issuance or short-term debt. In fact, more than 70% of closed-end funds employ some kind of leverage. This is something that many open-ended fund structures like ETFs are restricted from doing. This enables CEFs to enhance overall returns and increase earnings. This is particularly advantageous, as many CEF managers focus on the long end of the bond curve.

That leverage, as well as the ability to trade below their net asset values, allows CEFs to be income machines with many monthly distributions. As a result, many closed-end funds offer yields that exceed those of other investment vehicles and comparable ETFs or mutual funds. For example, a municipal CEF may be able to pay 6 to 7% in dividends versus 3 or 4% for an ETF. This chart from BlackRock, highlights the extra yield available from CEFs in various asset classes.

Source: BlackRock

Those distributions can come from a variety of sources, including interest, dividends, capital gains, and tax-advantaged returns of capital. Additionally, many closed-end funds have the ability to distribute capital gains throughout the year rather than at the end of the year like mutual funds and feature managed distribution plans that create a steady distribution schedule for investors.

Because CEFs raise money via an IPO and trade on an exchange, managers don’t need to worry about capital fleeing the fund. This allows them to be fully invested which removes cash drag. It also allows them to take advantage of illiquidity premiums. Illiquidity premium refers to the incremental return that an investor may receive for owning an asset that cannot easily be converted to cash at fair market value. Many bonds, leveraged loans, CLOs, and other fixed-income asset classes fall into this category.

Because of the fixed number of shares, as we said, CEFs can trade at a discount to their actual values. This allows investors to potentially buy stocks and bonds for a fraction of their value. This builds in a margin of safety to CEF shares. An added benefit to this is that sometimes the discount is wide enough or lasts long enough that activist investors will swoop in and demand that the discount be eliminated. This can mean selling the underlying assets or, more commonly, being converted to a mutual fund or ETF. This conversion instantly allows investors to profit on the discount.

Finally, like ETFs, closed-end funds trade on the major exchanges. This allows investors to take advantage of market conditions to time their buys or take advantage of real-time market conditions to sell at short-term premiums.

For investors, closed-end funds are a secret weapon when it comes to boosting income and building a portfolio. With more than 600 different CEFs covering all manners of bonds, stocks, and other asset classes on the market today, adding them to a portfolio is easy.

Now, some advisors swear by the structure and use them for 100% of their allocations. That might not be the best idea. Passive indexing and broad exposure of many of these asset classes still might be the way to go.

However, as a tool to add in select asset classes, using a CEF or two makes a ton of sense. For example, you could still hold broad bond ETFs holding the Bloomberg Aggregate index and then add a few selective CEFs covering corporate bonds or build out a high-yield portfolio of different CEFs covering these riskier asset classes. The same could be said for munis, using a broad index ETF and then several CEFs for additional spice. Finally, many CEFs fall under the headline of multisector income.

Our screeners at Dividend.com include CEFs.

These CEFs are sorted by their YTD total returns, which range from 6.5% to 15.8%. They have AUM between $100M and $1.65B and expenses between 0.86% and 3.4%. They are currently yielding between 6.1% and 13.1%.

Overall, closed-end funds offer unique benefits to portfolios that you can’t get in a mutual fund or ETF. And with that, they can be a powerful tool to add extra alpha to a portfolio, boost income, and add a larger margin of safety to investments. In the end, closed-end funds should be on your investment menu.

Closed-end funds are quirky. But many investors are missing out on the benefits that CEFs can provide. From higher yields to the ability to hold illiquid assets, the fund vehicle is one to consider when constructing your portfolio.