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Crack Open Closed-End Funds to Avoid the Relevance Paradox

Follow these rules to avoid CEF disappointment.

Mike Taggart, 10/10/2011

Income-seeking investors have long known the attraction of closed-end funds. With their use of leverage, income-oriented investment strategies, and ability to make regular distributions, most closed-end funds were built to deliver payment streams.

But all too often, investors don't get the results they were expecting. Simply put, some investors--largely unfamiliar with closed-end funds--do not understand what they've invested in until it's too late. Having reached a poor outcome, they conclude that the allure of closed-end funds isn't worth what appear to be hidden risks. It's a symptom of the relevance paradox.

This paradox arises because, for any given issue, we only gather information that we believe is relevant. If you believe that closed-end funds are just like stocks (after all, they trade on an exchange just like stocks), you will apply your stock-assessing methodology to closed-end funds and reach a largely uninformed conclusion.

The same result will occur if you treat closed-end funds as bonds or traditional open-end mutual funds. The relevance paradox, then, causes investors to make the wrong--or at best a shaky--conclusion about the quality of the closed-end fund they are investing in.

For income-oriented investors, this can lead to real headaches. Unaware that their closed-end fund's income payments include a component of return of capital (in some limited cases), investors get frustrated when their total return declines and their payment gets cut. Unaware that their fund produces high income primarily through heavy use of leverage (in many cases), they are shocked by the volatility of their returns. Concluding that closed-end funds are just too risky and complex, they sell positions at a loss and forswear future use of the investment vehicle.

In fact, closed-end funds are a great investment vehicle for income-seeking investors. Among funds that distribute payments more often than annually, the average distribution rate at the closed-end fund's share price is 7%, without taking into consideration the underlying asset class.

Knowing what questions to ask before purchasing a closed-end fund can set investors on a path toward a positive investment outcome. Of course, nothing is ever guaranteed. But following a few rules and understanding the typical mistakes closed-end-fund investors often make can make for a less stressful investment experience.

Rule 1: Stay Focused on Total Return
Closed-end-fund investors get the share-price total return, but it's important to keep an eye on the net-asset-value total return because it shows how successful a manager has been with his or her portfolio.

For income-oriented investors, this rule is crucial. Remember, income is only one component of total return. Closed-end funds, like open-end mutual funds, have to distribute their net income and capital gains every year in order to maintain their tax-free status. This income is taken from both the net asset value and the share price. In addition to the income component, total return also consists of a change in the price (NAV or share price).

Total Return = (Change in Price + Distributions) / Beginning Price

Sometimes, as we will get to shortly, closed-end funds with large distributions are paying out more than they actually can afford to pay out. This has a detrimental effect on the net asset value.

If you come across a fund paying out significantly more than what its underlying asset class pays out, check to see how the fund is doing this. It is possible that the large distribution is coming at the expense of total return.

For the most part, investors do a really good job with this rule. Good total-return performance by a closed-end fund is rewarded in the market place. By following this rule, investors can avoid investing in a fund that really isn't earning its distribution.

Rule 2: Never Pay Significantly More Than NAV to Get the Income
Finding a closed-end fund that is trading at a discount is typically a good thing for income-seeking investors because of "yield" enhancement. If a fund's portfolio is generating a 5% return and the share price is 10% below the NAV, the investor will experience a 5.5% return, all else being equal.

As Exhibit 1 shows, most regular-distributing closed-end funds trade at a discount. In fact, the average discount for all closed-end funds over the past 10 years has been 4.4%.

The exhibit also shows the relevance paradox at work. Notice that all of the funds trading at a premium have distribution rates of 5% or more and that the funds trading at ludicrous premiums greater than 40% are paying out 15% or more of their NAVs. Investors in the latter funds, seeing the large distribution rates, are likely making the wrong assumptions and setting themselves up for disappointment.

Paying up for high distribution rates seems to make sense. If Fund A is paying out 15% of its NAV and category peers are paying out 10%, investors should drive up the share price of Fund A until--at the share price--all the funds in the category are paying roughly the same percentage. This would happen if the category peers traded at NAV and Fund A traded at a 50% premium. It seems like this is market efficiency at work in the real world.

But there are two dangers to paying up for the income component of total return.

First, paying a high premium endangers the prospects for a positive long-term total return. When purchasing a closed-end fund at a large premium, investors--whether they know it or not--could be engaging in the "greater fool" theory of investing. Either they are betting that when it comes time to sell the fund, a greater fool will emerge to purchase it, or they are wagering that the net asset value will eventually increase to match or exceed the current share price. I am not one to advocate only purchasing a fund at a discount. Premiums and discounts tend to persist, and paying a slight premium to gain access to a unique investment strategy could at times make sense. But paying 10% or more above net asset value doesn't make much sense to me. Instead, it smacks of recklessness. Over the course of a market cycle, funds tend to trade at both a discount and a premium. Investors purchasing a fund at a 50% premium to acquire a 15% distribution rate are putting themselves at risk of seeing their fund's share price decline significantly, leading to a capital loss.

Second, a fund paying significantly more than its category peers is likely to be paying out an unsustainable distribution. Several studies have shown that the largest determinant of discounts and premiums is a fund's distribution rate. In fact, most closed-end funds trading at significant discounts are equity funds that pay out capital gains once a year. You should avoid a fund that has a significantly higher distribution rate than its category peers and is also trading at a significant premium to its NAV. 

Rule 3: Know How the Income Is Being Generated
Probably the least-understood concept of closed-end-fund income is the source of the distribution. Investors often belie this misunderstanding by referring to closed-end-fund distributions as "yield" or "dividends." In fact, there are three general sources of income: net investment income (coupons paid by fixed-income securities; dividend from equities), realized capital gains, and return of capital. The first two components are rather straightforward. Return of capital is where problems arise.

The first step in figuring out where the income is coming from is to look at the component of the distributions. Funds are required to provide estimates for every distribution they make, and at year-end, the actual amounts are finalized on the tax statements. Return o capital arises when funds are reaching to meet their distribution targets. These targets arise when funds that make payments more often than annually plan their upcoming distributions. For example, a fund may decide that its portfolio can sustain a $0.50 distribution amount every month. In some months, the fund may not generate $0.50 in net investment income or realized capital gains to cover the distribution. Therefore, the amount leftover will be ascribed to return of capital.

Now, to be sure, most funds do not return capital. Our purpose here is just to draw awareness to the issue. In fact, return of capital comprises only about 25% of all closed-end-fund distributions. However, when a fund does have a component of return of capital, it is the predominant component. So, if you come across a fund that returns capital to shareholders, you have to decide whether or not that fund is truly generating its distribution or if it is simply padding its excessively large distribution rate with investors' own money being returned to them.

The way to do this is to figure out if the amount of the distribution is eating into the NAV of the fund. If a fund has a $10 net asset value at the beginning of the period, distributes $0.50 per share, and ends up with a net asset value at or above $10, then unrealized capital gains (a potential source for return of capital) are the source, and we would consider this constructive return of capital. However, if the ending share price is below $10 per share, then odds are the distribution included some of the investors' own money.

Again, this is a big issue for only a few closed-end funds. It doesn't apply to funds invested in master limited partnerships; these funds receive return of capital from the underlying investments and simply pass it on to their own investors. And the tax treatment of return of capital can be beneficial. But, by an large, savvy closed-end-fund investors avoid funds that have a history of distributing a significant portion of return of capital.

The second step in figuring out where closed-end fund's income is coming from is to look at the portfolio. For example, if you come across a fund investing in equities that has an objective of distributing 25% of its net asset value every year, stop and ask how the managers can possibly do this. After all, the typical equity pays out only 2% or 3% of its value every year as a dividend. What is it about the investment strategy or the distribution policy of such a fund that allows it to pay out so much? Once you know the answer, you can then decide whether you are comfortable enough with the fund's approach to include it in clients' portfolios.

Rule 4: Assess the Use of Leverage
Closed-end funds often use leverage in an attempt to improve their returns. The Investment Company Act of 1940 regulates the amount of leverage a closed-end fund can use. So-called " '40 Act leverage" includes preferred shares and issued debt instruments. However, some funds use what is called "non-'40 Act leverage" to effectively position the fund for outsized returns. Such leverage can include various investment strategies that monetize the portfolio holdings, generating more cash that can be put to work, such as tender option bonds or mortgage securitizations. Using futures and options strategies also creates effective leverage. It is important to know what a fund's total leverage ratio is and whether the underlying portfolio holdings also include leverage components.

The average closed-end fund has a 30% leverage ratio, which means it is borrowing $0.30 for every $1 of net assets that it has. However, as the accompanying exhibits show, the range of leverage is immense, with total leverage ratios anywhere between 89% and 0%.

The benefits of leverage include higher income generation by the fund. For example, if an unleveraged portfolio generating income of 5% of assets issues debt equaling 50% of net assets, the underlying portfolio could then generate income of 7.5% (minus fees and leverage costs) of net assets.

The risk of leverage is that, by its nature, it creates volatility. For example, assume that a fund's capital structure is $100 million of shareholders' equity and $50 million of debt, giving the fund total assets of $150 million. If the underlying portfolio value decreases by 10% in a market downturn, the total assets will fall to $135 million, and shareholders' equity will fall to $85 million. Thus, a 10% market move results in a 15% portfolio move because of the 50% leverage, whereas an unleveraged portfolio in the same scenario will only move 10%.

For investors, there are several questions to consider.

First, is the increased distribution rate sufficient to offset the added volatility that ca be expected from a leveraged portfolio? This is difficult to assess, but Exhibit 2 offers a guide. Notice that some highly leveraged funds offer the same distribution rate as unleveraged funds. Exhibit 2 masks differences in the underlying asset class of the closed-end funds. But, if given the choice between two funds offering the same distribution rate, choosing the one with less total leverage should lead to less future volatility.

Second, given that investing in closed-end funds trading at a premium and investing in a leveraged fund both entail risks to total return potential, avoid paying significant premiums for leveraged funds, regardless of their distribution rate. As Exhibit 3 shows, the market tends to disregard leverage when determining the share price for a closed-end fund. Further, our own analysis shows that it does not matter whether the leverage is from '40 Act leverage or non-'40 Act leverage, the market doesn't pay attention to either form. Given that leverage should result in excessively positive total returns (relative to a benchmark index and unleveraged category peers) in up markets and excessively negative total returns in down markets, one could unwittingly conclude that the leverage is "priced into" the share price, but again, this doesn't seem to be the case.

Finally, investing in a leveraged closed-end fund will involve increased total-return volatility. Perhaps the largest reason that former closed-end fund investors eschew the use of the funds is because, when push came to shove, they were not prepared to handle the roller-coaster ride they had unwittingly embarked upon at purchase.

Ask Questions
Closed-end funds are, by and large, great investment vehicles for income-seeking investors. Understanding how they work and when to place them in a portfolio can lead to better long-term performance. However, the relevance paradox is always with us, though by definition we do not know it. When it comes to investing in general, one can never ask too many questions.

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