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Three Satellite Funds for Recent College Grads

Younger investors should eschew common wisdom and look toward these funds for supporting roles.

Steven Pikelny, 06/01/2012

Many fresh college graduates are finding themselves saddled with crippling student loan debt and thrust into the real world with few job prospects. However, a lucky few are debt-free and soon to be gainfully employed. Long-term investment might not be a financial priority for the former group, but it is likely on the radar for the latter. With the pending retirement of baby boomers fueling an endless search for income, however, the investment needs of these younger investors often get overlooked.

For most college grads with little investment experience, the prospect of creating a portfolio can be daunting. They know that they should be investing their graduation cash or a portion of their new salaries, but they have no idea how to go about doing so. A friend of mine in the graduating class of 2012 recently came into some graduation money and knew two things: that he should probably invest this money instead of squandering it on fancy tech gadgets and that I know more about investing than he does. He came to me and asked the simple question: "What can I invest in now and not have to look at for the next 40 years?"

There is no easy answer to this. If managing a portfolio was as easy as using a George Forman Grill, investors would gladly prefer to "set it and forget it" over paying an investment manager. Occasionally rebalancing a portfolio of funds can help one reap the benefits of long-term investment with minimal effort. Many seasoned pros would likely recommend open-end funds, as they provide access to a broad basket of securities without having to devote copious amounts of time and effort. Others would likely recommend passive exchange-traded funds, as they charge lower fees and take away the management equation, which can be potentially problematic over longer time frames.

Closed-end funds, or CEFs, typically do not come to mind when considering the needs of young investors. Instead, CEFs are usually viewed as income-generating vehicles for retirees rather than total-return vehicles for investors in their twenties. Our recent readership survey supported this notion, reporting that most CEF investors like the fund vehicle because it typically provides steady income and helps them achieve their retirement needs. Sixty-six percent of survey participants were 60 or older, and 54% were already retired. Nevertheless, younger investors should not let these statistics scare them away.

Why Should Younger Investors Consider CEFs?
Common wisdom states that stocks outperform bonds in the long run. While this may be good advice, it is also true that diversification of asset types, even over long time periods, can be valuable. For example, one popular factoid circulating around the end of 2011 stated that U.S. Treasuries outperformed the S&P 500 over the trailing 30-year period. Investors should not expect this to happen over the next 30 years but should also not rule out the possibility that unforeseen market conditions could throw common wisdom on its head. Even with a core allocation to stocks, other asset classes such as fixed income and real estate can play an important diversifying role.

For longer time horizons, CEFs have two main advantages over other fund vehicle investments. First, they can use leverage. This allows funds to amplify their distributions well beyond levels paid by ETF and open-end peers. Leverage does increase volatility as well as returns, but this should be less of a concern if steady income is not a prerequisite. What's more, reinvesting these high distributions should produce high total returns over the long haul. Second, the closed capital structure of CEFs allows them to invest in a broader range of assets. While open-end funds and ETFs are constrained by liquidity factors and fund flows, CEFs can more easily move in and out of attractive, but illiquid, assets.

For the sake of diversification within longer time-horizon portfolios, we have highlighted three CEFs that could act as effective satellite holdings within a young investor's portfolio.

Aberdeen Asia-Pacific Income Fund FAX
This fund is unique in that it is one of the few funds focusing exclusively on the Asia-Pacific debt market. Holdings are typically split evenly between Australian sovereign debt and the sovereign debt of developing Asian countries. Because many of the Asian countries are less economically developed and have more-fragile political infrastructures, many investors in the Western hemisphere are understandably deterred from investing in these regions. However, these countries are growing at an incredibly fast clip and are increasingly taking up more of the global economic pie. What's even more attractive is that many of these countries have notably low debt/GDP ratios. This debt seems comparatively safe next to the eurozone.

Steven Pikelny is a closed-end fund analyst at Morningstar.
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