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It's Time for a Reality Check on Closed-End Funds

CEFs have a role in risk-tolerant portfolios.

Mike Taggart, CFA, 04/26/2013

In a recent article, I pointed out that adding closed-end funds, or CEFs, to a portfolio has several benefits for those seeking increased income. Judging from the comments to that article, several Morningstar.com members have already figured this out. For those of us who are heavily focused on CEFs, this notion is common sense. However, most investors are not focused on CEFs, so further explanation and a real-life example may be helpful in gaining a better understanding of those potential benefits.

Higher Income Entails Higher Complexity, but That's No Deal Killer
It is no stretch to state that most CEFs were built to provide income. In fact, providing a high level of income is listed as an investment objective for most CEFs. This isn't some recent gimmick. Two facets of the CEF regulatory framework help them achieve their income goal. First, their closed-end structure means they can invest in more-illiquid and often riskier or higher-yielding securities with much less risk of being forced to sell securities or hold cash to meet shareholder redemptions. Second, they are allowed to use leverage within strict regulatory guidelines, which can augment their income-producing potential.

Despite their pervasive income focus, it is not difficult to understand why most investors overlook closed-end funds. Compared with the open-end mutual fund industry, the CEF universe is small--about $300 billion in total assets. Because most CEFs use leverage, their net asset values and share prices are typically more volatile than comparable open-end funds, which may increase the chance that investors use them ineffectively. Because fund families usually assess management fees on both net assets and leveraged assets, the total expense ratio to the shareholder usually is higher than that of comparable open-end funds. Because CEFs have both an underlying net asset value and a share price, investors must understand and take into account share price premiums and discounts before investing. On top of all this, it's important to understand the components of CEF distributions. For many investors, CEFs are simply too complicated to tangle with.

Even so, a little bit of education can go a long way. CEF aficionados understand that leverage increases risks but also magnifies total returns. We've written about this in several places, including an article about a year ago, and we have an educational presentation available in our CEF Solutions Center. They also understand that leverage trumps expense ratios as a driver of CEF total returns, about which we've also written.

Essentially, to achieve the higher income offered by most CEFs, investors must be willing to take on increased potential volatility and pay higher underlying expense ratios. That realization may be off-putting, but for investors who put it in proper context, CEFs are a powerful tool that can help them reach their investment goals. Some investors' risk profiles may not be suited to closed-end funds, but our view is that this is a decision that every individual should make for themselves rather than ignoring or dismissing CEFs en masse as an investment option. We provide guidance through our Solutions Center, CEF articles, Morningstar Analyst Ratings, and our CEF Discussion Board. Ultimately, it is the investor's choice, and it would be wrong to throw the baby out with the bath water.

Let's Set the Stage for a Real-Life Example
Even if you spend the time learning about CEF-specific topics, it can be difficult to understand how exactly they can enhance your portfolio. For that reason, we have constructed three representative portfolios. These portfolios aren't recommendations--they are intended to illustrate the potential benefits of adding CEFs to a representative portfolio of mutual funds. The core of each portfolio comprises a large-blend equity fund, a foreign equity fund, a U.S. fixed-income fund, a global fixed-income fund, and a municipal-bond fund.

Our purpose here is to show what the volatility (as measured by standard deviation) and total return would have been over the past three years, what the most recent expense ratio would have been, and what the currently expected distribution rate would be. For mutual fund investors familiar with trailing 12-month or 30-day SEC yields, our view is that the distribution rate at share price is the better forward-looking indicator of a CEF's future income-generating potential. To make an apples-to-apples comparison between the mutual funds and CEFs in our portfolios, we applied the CEF distribution rate calculation to the mutual funds: We took each fund's most recent distribution, annualized it (multiplied by 4 for quarterly payers and by 12 for monthly payers), and divided by the current net asset value. This mimics the calculation used for the CEF distribution rate at share price, except that for CEFs the denominator is the share price because that's what investors would be receiving.

Pulling the statistics together for the total portfolios requires further explanation. For the three-year annualized total returns, we used the initial allocation percentages on a $1 million portfolio, calculated the monthly returns, and then annualized the returns from the value ending April 18. For standard deviation, we used the volatility of the monthly total returns. For the distribution rate, we took the individual, current fund distribution rates (as mentioned above), multiplied those by the assets held in each fund as of April 18 to get the expected distribution amounts, and then divided by the portfolio value as of April 18.

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

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