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Be of Good Cheer, CEF Investors

Ignorance, disregard, and befuddlement ensure that closed-end funds will remain opportunistic investments.

Mike Taggart, CFA, 04/12/2013

Most self-described investment prognosticators simply crack me up. One will write about generating investment income but ignore the one investment vehicle (closed-end funds) best suited to deliver income. Another will write about an appealing group of funds and fail to mention that CEFs in that same group have posted better performance. Others--usually those selling investment services--attempt to complicate CEF investing so much that readers are left thinking that only professionals should invest in CEFs. Such stances help make the closed-end fund market inefficient, which presents opportunities for CEF investors.

How many articles have been written, typically with a retirement focus, that highlight securities paying 3% and 4% dividends? I feel bad for people reading such articles. I don't know of an income-focused CEF offering such low distribution rates. Granted, CEFs may not suit the risk profile of a particular investor. However, would it hurt to mention the higher distributions offered by CEFs? Leverage and the ability to invest in less-liquid securities (because there is no fear of redemptions, contrary to open-end funds) allow CEFs to pay out higher distributions. Not across the board, but in select cases.

Prognosticators who know of CEFs but don't mention them do their followers a disservice. Do leveraged CEFs exhibit more volatility than their unleveraged mutual fund peers? Almost certainly. Are they more complicated investments than mutual funds? Absolutely. But nobody--not even the closed-end fund executives that I know--would counsel an investor to stalk their entire portfolio with CEFs. Being ignorant of the benefits of CEFs, especially for generating income, does not serve investors well.

Adding a few CEFs to a portfolio is going to benefit in two ways. First, the inherent diversification of the portfolio is going to offset the CEFs' volatility. Let's say an existing portfolio has a three-year standard deviation (a measure of volatility) of 15 and delivers a 2.5% yield. Consider what happens when adding a 20% weighting of various leveraged CEFs, which are aligned with the existing asset allocation and have a three-year standard deviation of 22 and a distribution rate at share price of 8.5%. Overall, the portfolio would then exhibit a three-year standard deviation of 16.4 and a distribution rate of 3.7%.

Would you be willing to increase the volatility of your portfolio by 1.4 points (or 9.3%) for a 48% increase in income? Many conservative investors would not accept this trade-off, which is understandable. After all, the volatility metric and the distribution rate rely on measurements of past performance and the last distribution. But I believe that many investors would willingly, even eagerly, accept such a trade-off. Unfortunately, they don't get the word. In my opinion, prognosticators often allow their own ignorance of CEFs to cloud their advice. Their audience should be given the facts--all of the facts--and be allowed to decide for themselves if CEFs are suitable for investment.

Ignorance is one reason why CEF investors should smile: We have a leg up on the investing masses when it comes to generating income from our portfolios.

Another camp of prognosticators simply acts as though CEFs don't exist. (At least they don't accuse CEFs en masse of wrongdoing, as the first group does.) Whether you realize it or not, CEFs usually aren't mentioned in most articles purporting to show all available investment options. Such articles typically focus on stocks, mutual funds, and exchange-traded funds, but there's no mention of the closed-end fund investment vehicle.

To be fair, CEFs are such a niche that oftentimes this type of prognosticator is likely unaware of CEFs. But there are times when it's evident that the author is aware and simply chooses to overlook them. Why would someone do this? In my view, the reason is simple: mentioning CEFs would make the investment vehicle he or she is touting look bad. For instance, if you're writing a story about investing in India, and you want to highlight how stocks are the best method of doing so, then you certainly don't want to shed light on the fact that investing in an India-focused fund would offer the same exposure with less risk. A fund's portfolio would diversify the idiosyncratic risk. So the next time you read about an investment category or a market sector, ask yourself if there is a CEF that offers similar exposure and, if so, why wasn't it mentioned?

With most investors left in the dark, those of us in the know have another leg up on the market competition.

As a parent, I spend many Friday evenings watching (and rewatching) various kids' movies. One of my favorites is Pixar's Ratatouille, which is about a rat who becomes the best chef in Paris. The movie's underlying premise, as espoused by the former head of that city's most famous restaurant, is that anyone can cook, and this leads to the rat's culinary education. A restaurant critic vehemently opposed to this idea creates the tension within the story.

Many prognosticators do not want you to believe that anyone can cook, that any investor can learn how to invest in CEFs.

Many articles aim to help investors to better understand CEFs. They might focus on leverage, return of capital, or the vagaries of net investment income accounting. But one can't get away from the fact that most articles of this type are written by financial advisors. Typically, such articles serve to befuddle an issue. The usual structure is as follows:

So and so has written such and such about this CEF issue. This issue is important for various reasons. So and so is incorrect in his view. The issue is far more complicated than he or she lets on. It's easy for investors, such as yourself, to be confused. Signed, a person who profits from investing other people's money.

This tactic clearly can be seen as an indirect method of promoting one's investment services, and it is increasingly prevalent.

At Morningstar, our belief is that any investor can learn the basics of CEF investing. If you're willing to invest the time to learn how to avoid the major mistakes, you can profit from adding CEFs to your portfolio. To help with this endeavor, we have a solutions center that offers education on a variety of CEF issues, and these weekly articles serve to discuss various CEF issues.

So smile, CEF enthusiast. You know how to profit from CEFs.

Click here for data and commentary on individual closed-end funds.

Hear Morningstar Experts at Upcoming Forum
Join Morningstar on Wednesday, April 24, 2013, at Capital Link's 12th Annual Closed-End Funds and Global ETFs Forum in New York. Scott Burns, director of fund research, and Mike Taggart, head of U.S. closed-end fund research, will be moderating sessions. Click the above link for the agenda and registration details. 

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

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