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More Investors Turning to CEFs for Portfolio Needs

More investors, especially advisors, are putting money into CEFs. We're here to facilitate that evolution.

Mike Taggart, CFA, 09/07/2012

It seems that many financial advisors are increasingly turning to closed-end funds to meet their clients' needs, if my experience is indicative of overall trends. Emails and conversations have led me to this view: Advisors, attempting to mitigate fund fees and to provide their clients with better total return opportunities, have begun to consider exchange-traded funds for client portfolios. This movement isn't new, but I believe it's gaining pace. As they begin to study ETFs, many advisors also come across closed-end funds and take an interest. If they can get comfortable with the use of leverage, discounts and premiums, and other CEF items, they see the benefits that CEFs can garner for their clients.

Fund flows and CEF discounts/premiums seem to bear this out. Much has been made about the flow of money out of equity mutual funds and into fixed-income mutual funds. What is less well known is that the billions of dollars involved aren't all flowing from equity products into fixed-income products. Instead, a lot of the money is being redeemed from equity mutual funds and going into equity ETFs. What's interesting, though, from a CEF perspective, is that the money doesn't seem to be flowing into equity-oriented CEFs. At least, such flows don't show up in the discounts of such CEFs. In fact, the average discount of the equity-focused CEFs as a group is about where it has been over the past three years, at 4.7%. This is interesting but not necessarily surprising. Investors new to CEFs don't necessarily equate income with equity except for dividends. Furthermore, with the knowledge that CEFs often use leverage--and many newbies believe all CEFs use leverage--the thought of adding a leveraged equity fund to a client portfolio must seem like sheer madness.

However, when we look at the discounts and premiums of typically income-oriented asset classes, it's clear that advisors and investors in general have taken an interest in CEFs. Taxable fixed-income CEFs, national municipal CEFs, and state municipal CEFs all sport average and median premiums to their underlying portfolios. In fact, of the 433 CEFs that we would place in these three groupings, 188 still trade at discounts. But, significantly, the average discount or premium for all three groups is higher than it has been over the past three years. This reflects the fact that funds investing in areas traditionally thought of as income-generating are seeing greater interest, and since the bulk of CEF investments are made by advisors it is logical to conclude that this greater interest is on the part of those advisors.

A Typical Anecdote
In early August, I was speaking with a friend about investments. He's a registered investment advisor. Although I've known him for a few years, we had never discussed work. I believe the gist of our conversation shows what many advisors consider when it comes to investing in CEFs. He told me that he was increasingly turning to ETFs to meet his clients' financial needs. He had grown weary of paying high expense ratios for fund managers who maybe, over the long term, would beat a market index. ETFs offering low fees and tightly benchmarking an index seemed a good solution. However, despite the well-known tax advantages of most ETFs over mutual funds, he was having trouble figuring out how to craft an ETF-focused portfolio into an income-producing portfolio. He's a smart guy and he was figuring it out, but it was a challenge nonetheless.

I, of course, immediately swung the conversation to closed-end funds. He had heard of them but wasn't overly familiar. I told him about how most are built to produce income. He objected that they use leverage to achieve those high distribution rates. (I told you he is a smart guy.) I interjected that while leverage can lead to volatility and definitely adds risks, the Morningstar risk-adjusted returns for CEFs compare very favorably--not across the board, but in the majority of cases we have seen--with open-end and ETF category averages. CEF investors on average have been well compensated for the higher risks. He objected to the high fees that CEFs often have. I pointed out that interest expense from leverage has to be reported as an expense item, even though the leverage over time typically works out in the investors' favor. He was interested in learning more.

I sent him articles and reports (he's a Premium Member of Morningstar.com and has access to Morningstar Advisor Workstation anyway). After he looked them over, he had two thoughts. First, he wasn't interested in the equity-oriented CEFs that I had pointed out. To him, they were too volatile, likely from leverage and the fact that the discounts and premiums swing more than the underlying net asset values. He didn't feel comfortable putting them into client portfolios. I've since sent him information on covered-call CEFs, which typically have better risk- (volatility-) adjusted returns than their open-end category peers (most of which don't write options against the portfolio). Second, he was highly interested in the fixed-income-oriented CEFs. Yes, they looked riskier because of leverage. But, significantly, the volatility created by the one investment could potentially be offset by other portfolio holdings while the income distributions provided a solution to his initial problem. He is continuing his investigations.

I include this anecdote because I believe this is occurring more and more frequently across the country in advisors' offices. My suspicion is that my friend will learn more about CEFs, acquire greater comfort about the potential risks and rewards offered by CEFs, and add a CEF to his clients' portfolios. It's likely to be a tepid approach at first: "Let's see how this works out in real life." But I also suspect that, over time, as he sees how CEFs perform, more CEFs will find their way into the portfolios. From the many emails I receive from advisors, that would be the typical progression.

CEFs are relatively thinly traded. It doesn't take much marginal buying to increase their share prices above the rate of return on the NAV. This is why discounts have narrowed and, in many cases, turned into premiums. One advisor transitioning a small percentage of clients' portfolios into a CEF, aggregated over the broad spectrum of thousands of advisor offices across the country, recurring week in and week out, over time will have--and has had--an effect on the discounts and premiums that CEFs trade at.

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