Closed-end funds are a misunderstood investment. Unfortunately, when something is misunderstood, it is often pushed to the side with something else taking its place. For long-term investors though, closed-end funds are investments worth taking the time to understand.
They can provide a wide array of benefits to investors’ portfolios and they can help provide unique insights into retail investors’ perceptions of the market. For the purposes of simplicity, in this article I will briefly explore four critical elements that warrant a further look at closed-end funds: diversification, their ability to stay invested, their strategic use of leverage, and discounts.
First, in terms of diversification, closed-end funds offer investors a variety of securities within a single portfolio, which is oftentimes extremely difficult to accomplish on an individual level. This is true for both equity and fixed income closed-end funds.
For example, from the equity side, investors may find it difficult to adequately diversify across managers, sectors, market capitalizations, or geographical regions. Additionally, investors may not be able to use options or use other hedging strategies in a cost effective manner to further diversify their portfolio. This is something that equity closed-end fund investors can accomplish relatively easily.
Alternatively, from the fixed income side, unless a portfolio is of a larger size, it is quite difficult to purchase a variety of individual bonds that spreads risks across various issuers, sectors, maturities, or portions of the yield curve. With fixed income investments, it is also much more cost effective to get this diversification through a relatively liquid investment vehicle, such as a closed-end fund.
While it is true that investors can sufficiently diversify their portfolios using open-ended mutual funds, this leads to my second key advantage: managers of closed-end funds don’t have to liquidate portfolio securities in the event many investors seek to sell at an inopportune time.
Next, the strategic use of leverage is also advantageous to closed-end fund investors. Through leverage, portfolio managers are able to borrow (through loans, issuance of various preferred securities, etc.) and purchase more securities in line with their stated objectives. While leverage can enhance gains, it can also magnify losses. The operative term to stress though, is the strategic use of leverage – where managers can choose the most appropriate form of leverage they see available.
The last critical advantage of closed-end funds is the ability to often buy them for less than the full value of their underlying assets – which is referred to as a discount. The ability to buy an undervalued investment at a discount and then sell that investment when the discount has narrowed, coupled with the income received while discounts narrow, provides an attractive total return profile for investors’ portfolios.
Discounts are also a key analytical tool because they provide insight in to retail investors’ perceptions. Because closed-end funds tend to be heavily utilized by retail investors and retail investors that invest across all asset classes represent a diverse cross section of the investing public, we’ve found that their tendencies are indicative of the market as a whole. What their tendencies then translate into are buy and sell signals through the discounts and premiums of closed-end funds.
By forcing investors to be contrarians at the right times, investing in closed-end funds at attractive discounts and utilizing indexing when discounts aren’t very attractive helps investors avoid the herd mentality that often plagues investors who solely index their portfolios and hope they are right.
On top of this, if a Board of a Fund isn’t managing the discount of a Fund or a manager isn’t performing sufficiently, investors in closed-end funds have the ability to annually vote on directors and propose actions to reduce the discount or improve a fund’s corporate governance procedures.
Simply put, we’ve found great value for clients’ portfolios by being active for value reasons (by investing in the closed-end funds at wide discounts), while holding certain passive investments for tactical exposure when values aren’t quite as attractive as we believe they should be.
To see if closed-end funds are something that you should look at further to achieve your investment goals, contact your investment professional to learn more. From my perspective, I do not believe that the benefits of using closed-end funds can be ignored.