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Are These Four Concerns Holding You Back From Closed-End Funds?

Feedback suggests four typical stumbling blocks for investors who are otherwise interested in CEFs.

Mike Taggart, 03/09/2012

Last month, I published an article suggesting that investors consider closed-end funds for their investment portfolios and providing a few rules of thumb for doing so. Aside from the readers' comments on the website, I also received several emails. From this feedback, there seem to be four significant hurdles keeping otherwise-interested investors from considering closed-end funds. While I agree all four have merit, I disagree with the wholesale dismissal of CEFs as an investment vehicle that some readers seem to advocate. For instance, long-time contributor BubbaB warns severely--and often--about the fact that most CEFs use leverage, thus making them dangerous. I would add "for BubbaB" because other investors likely have different risk profiles--not that I want to downplay the risks that leverage presents. The point is that investors should be aware of these issues and weight them on an individual basis.

Too Expensive
Comparing a CEF's expense ratio with that of an open-end fund can be misleading. Published expense ratios for CEFs look relatively high for two reasons. First, due to securities regulations, if a CEF uses debt (including lines of credit) for leverage, it has to report the interest expense in its total expense ratio. If a CEF uses preferred stock for its leverage, it does not have to report distributions made to preferred shareowners in the expense ratio. Thus, debt-leveraged CEFs look relatively expensive. It would be the height of foolishness to suggest that interest expense is not an actual expense. It is. Bear in mind, though, that in this low-interest rate environment, it typically makes sense for a fund to borrow at low rates and invest the borrowings to reap profitable returns. On our website, we attempt to show a fund's adjusted expense ratio, which excludes interest expense, in order to provide a better comparison with open-end funds. Anecdotally, when we've come across funds offered by the same family, running very similar investment strategies, and with the same portfolio managers, the CEF has had a lower adjusted expense ratio than its open-end counterpart; we believe this warrants future study.

While I'm generally willing to explain away the reported higher expense ratio of debt-leveraged CEFs when it comes to interest expense, I'm not willing to do so when it comes to the second potential reason for higher expense ratios: management fees. The prevailing practice among CEFs is to charge management fees against total assets, which includes any leverage the fund has. It's one thing, in my mind, to charge management fees on money that investors have decided to invest in a fund and quite another to charge such fees on borrowed money that fund executives themselves have decided to raise for the fund. Consider a CEF with $500 million in net assets, another $125 million in leverage, and a 1% management fee. If the management fee was levied solely against the net assets, the fund would garner $5 million in fees every year; if levied against total assets, the fund would garner $6.25 million. Such fee structures, then, give the incentive for funds to use leverage to boost their own revenue, in this case by 25%. I often wonder how any executive or director could argue against such leverage, even if less leverage was believed to be in shareholders' best interests, without committing career suicide. Still, levying management fees against net assets and leverage is the predominant pricing model. As long as the leverage is invested to produce returns that exceed its cost (both in terms of interest or preferred distributions and the management fee), then it is profitable to the common shareholders. In an environment with higher interest costs, this will get trickier for funds using floating interest rate leverage.

There are also other potential costs, including wide bid-ask spreads caused by illiquid markets, brokerage commissions, and the fund's turnover ratio. Even more details about CEF expenses can be found in our Solutions Center.

It should be clear from the expenses that leverage plays a large role in CEFs. It not only affects expense ratios, it also magnifies volatility (the up-and-down moves in net asset values and share prices) and distributions (often mistakenly referred to as dividends or yields). Of the 630 CEFs in our database, a full 580 have some sort of leverage as of March 7. To be fair, some of that could be due to rounding errors between total assets and net assets. Nearly 100 CEFs are listed with total leverage of less than 1% of net assets. Still, it's clearly important for new CEF investors to realize that the vast majority of CEFs use leverage.

Many investors, including BubbaB, don't like leverage. Only you know what your risk profile is. From an analytical standpoint, leverage isn't necessarily good or bad. Still, a few pointers may be in order. After the financial disasters of 2007-08, some investors see the word "leverage" and suspect that CEFs are leveraged to the tune of an AIG, Lehman Brothers, or Bear Stearns. In fact, those entities had borrowings many times the size of their underlying assets, whereas only one CEF according to our database has leverage above its net assets (PIMCO Strategic Global Government RCS seems to be borrowing $1.15 for every $1.00 in net assets). Of all leveraged CEFs, the average leverage amount is currently 37.5%. That means that on average, leveraged CEFs are taking on $0.375 for every $1.00 they have in net assets. I want to detail what this means because some fund families and data points divide the leveraged amount by the total assets (to make the leverage seem smaller and to match regulatory ratio definitions), and that's not what I'm doing here.

There are two benefits and three downfalls to leverage in CEFs. The benefits are potentially higher risk-adjusted returns and higher distribution rates. Risk-adjusted returns take into account the volatility of the fund. So if a fund posts returns that are higher than the magnified volatility adjustment, the risk-adjusted return will be higher as well. You get leveraged upside. Distribution rates are pretty straightforward. If the fictitious $500 million net asset fund mentioned above generates 5% of net investment income from its portfolio, it will net $25 million for potential distributions. Adding in $125 million in leverage, the potential distribution rises to $31.25 million. Even factoring in a 1% management fee and a 2% cost of leverage, the leverage will have benefited investors to the tune of $2.5 million in additional potential distributions.

The first two negatives to leverage are closely related to the benefits. First, if a fund's cost of leverage and other leverage-related expenses exceed the income generated by the leverage, the leverage is unprofitable for the fund. Second, if the underlying assets in a fund decline, the decline is magnified by the leverage. Take our fictitious fund again. If it's unleveraged, a 10% decline in the portfolio would lead to $450 million in net assets ($500 million - 10% of $500 million). If it's leveraged with the $125 million, a 10% decline will lead to $437.5 million in net assets ($500 million - 10% of $625 million). After all, the lenders don't suffer as much as common shareholders, if at all, in a downturn, nor do they profit in an upturn.

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