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Shock Claim: CEFs Are Not Just for Income

If you consider CEFs to be only suitable for income generation, you're missing the other side of the coin.

Mike Taggart, CFA, 11/11/2011

This week I traveled with two colleagues, Cara Esser and Steve Pikelny, to Manhattan for the Insight and Enlightenment into the World of Closed-End Funds conference hosted by CEFNetwork. You can see the presentations and listen to the recorded audio here. It was nice to meet new people, catch up with executives, and speak about closed-end funds, or CEFs, all day. Most of the funds represented at the conference were country- and region-focused. For the most part, such funds are focused on long-term capital appreciation, not on income generation.

Audience members asked a lot of good questions. One stuck with me throughout the day, on the flight home, and is still on my mind. A longtime CEF investor I respect asked a fund executive when his country-focused fund was going to address its minuscule distribution rate because "CEF investors want income from their funds."

This view is myopic and, I believe, has done great harm to the CEF industry. Most CEFs these days are created for income. Most CEF investors do want income. But the closed-end structure of CEFs can accommodate far more investment objectives than income generation, and in fact country-focused funds are one such investment strategy that benefits from the closed structure.

How can the singular focus on income harm CEFs? It stifles the introduction of new CEFs to the market (if a fund can't make a case for how it will meet a large-enough distribution rate, it won't make it through the IPO process). It causes some funds to stretch for "yield" (excess leverage, dubious income strategies, and return of capital). It entices investors to overlook total return in favor of a distribution rate. It leads many investors to forgo even considering a CEF to meet their investment objective (long-term capital-appreciation seekers mistakenly believe that CEFs are only for income-seekers). In short, the fallacy that CEFs are viable only if they distribute a high rate of income does damage to both the industry and its investors, in my opinion.

That the CEF structure is extraordinarily well-suited to generate income is true. But that's just one thing they are well-positioned to do. It seems, though, that in recent years many funds and most newly issued funds are income-oriented. As a result, funds created to take advantage of other aspects of the CEF structure have taken a back seat. Let's look at two big-picture investment strategies and objectives that I believe are well served in a closed-end-investment structure.

Income-Generation
We have written extensively on the income-generation potential of CEFs. They can use low-cost leverage to enhance their portfolios' yield. Currently, the average distribution rate for CEFs with managed or level distribution policies is 7.5%. That's a rather high rate in a low-interest-rate environment, and it doesn't even factor in the tax-adjusted yield from municipal CEFs. Twenty percent of funds with these policies are currently returning capital of some sort to investors, according to their own estimates of distribution sources, in order to augment their portfolio yields. The average total leverage ratio of these funds is 36.8%; this leverage increases such funds' net asset value performance volatility, but most investors overlook the higher risk for the benefit of the higher distribution rate. On the plus side, managed or level policies do seem to instill discipline on fund executives (as it does on executives whose corporations pay dividends), as their funds' risk-adjusted returns over one- and three-year periods are significantly higher than funds without such distribution policies.

Now, do investors expect their CEFs to make distributions? Do they reward funds with high (sometimes too-high and unsustainable) distribution rates? Typically, yes. The relationship between a fund's distribution rate and its discount/premium is well documented. Currently, there is a 0.58 correlation between a distribution rate and a discount/premium. No other variable comes close to exhibiting such correlation to a fund's discount/premium. On the other hand, Adams Express ADX committed to a 6% annual distribution rate back in September when its discount was 14%; currently its discount is wider than 17%. So, funds aren't always rewarded for formalizing a higher distribution rate.

I've heard consistently and often over the past 18 months that investors are increasingly interested in CEFs for income. This rumored interest, however, doesn't show up in the aggregate data. Surely if more investors were actually purchasing CEFs, we would see discounts narrowing across the board. The current discount for all CEFs on average is 3.95%, not far from its 10-year average of 4.4%. In fact, in March 2004, the average "discount" for all CEFs was a premium of 0.3%--that's a period when it is demonstrable that there was increased interest in CEFs. So, either today more and more investors are not interested in CEFs because of their income (it's a persistent, oft-told rumor) or there is more interest but it isn't translating into actual CEF purchases. Either way, it is irrefutable that CEFs are well-positioned to generate income for investors.

Capital Appreciation
While income, via its consequent distribution rate, is one factor of the total-return equation, capital appreciation is the other. When it comes to CEFs, though, this component seems to have been placed in the back seat by both investors and, more recently, fund executives. Return of capital diminishes capital appreciation, handing back capital to investors in order to bolster the distribution rate rather than holding on to the capital to reinvest it in the portfolio.

Last year, I wrote an article suggesting that value-oriented portfolio managers would find a closed-end structure more amenable to their natural investment style than the open-end structure. The reasoning is, essentially, that "hot" money inflows and outflows run counter to the value-oriented investment philosophy: Inflows come at the top of markets, when value managers have few investment opportunities; outflows come near market bottoms, when such opportunities are plentiful. A CEF portfolio isn't subject to the whims of its investor base (though its share price and subsequent discount/premium are). David Christensen, the portfolio manager of ASA Gold and Precious Metals ASA and a participant at this week's conference, pointed out that he has managed both closed-end and open-end funds; he finds there to be significantly fewer distractions with his CEF, and as a result he can focus on the portfolio and investment opportunities.

Country- and region-specific strategies can also benefit from a closed-end structure, especially if the securities on the local exchanges or in the local markets are relatively illiquid. The Insight and Enlightenment conference highlighted many such funds, which typically have long-term capital appreciation as their stated investment objective. Having a closed-capital structure gives such funds an advantage, I believe, because--as with value-oriented strategies--their portfolios are safe from inflows and outflows at disadvantageous times. Given the volatility of emerging-markets securities, investing in them through open-end funds is unnecessarily risky, in my opinion. Such funds are at risk of volatility from both local-market conditions and U.S.-based investor sentiment. In a downturn, this leads an open-end manager to sell shares to meet redemption outflows into a declining, typically thinly traded local market. CEF net asset values will, of course, reflect the downturn, but without the distraction of outflows, the CEF portfolio manager can focus on taking advantage of market opportunities.

A Full View of CEFs Will Help the Industry
We believe all investors should be focused on potential total return when searching for a suitable vehicle to meet their investment objectives. Fixating on the income component of total return, without regard to potential capital appreciation, will likely not lead to a suitable investment. While many CEFs are created and managed to provide relatively high distribution rates, it's important to always consider the bigger-picture total potential return and to ensure that the CEF is earning its distribution.

At the same time, investors and industry executives should resist the temptation to paint all CEFs into the income-generation corner. Are executives ceding the capital-appreciation corner to exchange-traded funds? Presumable unwittingly, many seem to imply that if investors are seeking income, they should consider CEFs but if they are seeking capital appreciation and better probability of achieving near-benchmark performance, then some other investment vehicle is likely more suitable. This doesn't have to be the case, as another advantage of CEFs, with their closed-end structure and their widespread use of leverage, is that they are well-equipped to have a fighting chance of beating their unleveraged benchmarks.

To see CEFs as suitable only for only income-producing investment objectives, though, stifles funds that have long-term capital-appreciation objectives and it also holds back the industry's long-term growth prospects.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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