CEFs have a role in risk-tolerant portfolios.

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.

For closed-end funds, it is also important to point out that the standard deviation, distribution rate, and total return reference the share price, not the net asset value. This is because the share price reflects the investor experience. With these stipulations to make comparisons more meaningful, we can proceed.

**Now, On With the Program **As illustrated in the table below, the first portfolio is constructed of open-end mutual funds over $2 billion in assets (that is, widely used), carrying a Morningstar Analyst Rating of Gold, Silver, or Bronze, and requiring reasonable minimum investments. Allocating 20% of capital to each holding would have created a portfolio that has provided a 6.94% annualized total return over the past three years, exhibited an 8.50 standard deviation, cost about 0.65%, and delivering a "yield" (or, in our example, distribution rate) of 2.50%. That's not too shabby, except for the distribution rate. This isn't to argue that investors could have attained a higher yield by choosing other mutual funds; I was attempting to choose funds that are well-known and offer a relatively high yield compared with other funds in their respective categories.

The second portfolio is constructed of leveraged closed-end funds with more than $200 million in net assets (as mentioned previously, the average closed-end fund is significantly smaller than the average mutual fund). I attempted to mimic the underlying asset-class allocation of the representative mutual fund portfolio, using Morningstar categories, with two exceptions. Clough Global Equity

* *

Now, let's compare the two portfolios:

* *

Our sample CEF portfolio has delivered a higher total return and is providing more income than the mutual fund portfolio. The annualized total return would have been about 73% higher than that of the mutual fund portfolio, and its distribution rate is currently 186% higher, reflecting its stronger income-generating potential. For this performance, the three-year standard deviation was only 2.12% higher--diversification benefits in action. However, its average current expense ratio is 198% higher.

Let's assess the trade-offs. Would it have been worth 2.12% higher volatility to achieve 73% more in total return and nearly twice the expected income? For some investors, yes, for others, maybe not. Investors who know to expect a bumpier ride from the CEF portfolio might be more willing to shoulder that extra volatility or may be more likely to use the portfolio effectively. That said, underlying markets could become more volatile going forward, sparking even more relative volatility for the CEF portfolio, and distributions could be reduced, making the income comparison less attractive. Given this, it is easy to understand why nobody I've ever spoken with--including industry executives--has suggested a portfolio stocked 100% with CEFs.

**Making Sweet Music Together**

Let's consider a third portfolio that combines CEFs with mutual funds. This is where diversification helps both portfolios. When one reads "diversification," thoughts naturally turn toward asset-class diversification. Some investors actually confuse closed-end funds with an asset class, which isn't the case: They are an investment vehicle, not an asset class. The beauty of diversification is that it can manage risk from a variety of sources. Essentially, by allocating a percentage of a portfolio to CEFs, investors can potentially reap the benefits of higher income while still reining in the overall volatility of their portfolio.

This third portfolio combines the funds from the first two portfolios. Our total allocation to CEFs across all asset classes (as defined by Morningstar categories) is 20% of capital. Essentially, for each underlying asset class we reduce the allocation in mutual funds to 16% from 20% and augment the asset class with similarly invested CEFs (4% to each asset class).

* *

This combined portfolio would have delivered an 8.00% annualized total return over the past three years, exhibited an 8.33 standard deviation, cost 0.90%, and would be delivering an expected 3.53% distribution rate.

* *

Here's where we see the benefits of diversification clearly. Compared with the mutual fund portfolio, the combined portfolio has delivered 15.3% more in annualized total return over the past three years. It is still nearly 40% more expensive than the mutual fund portfolio. But (and here's where it gets really interesting) the benefits of adding more funds--even leveraged closed-end funds--has pulled the exhibited standard deviation down by 2.0%. On top of this, expectations are that the combined portfolio is set to deliver 41.2% more in distributions than the mutual fund portfolio.

Suddenly, the trade-off becomes more palpable: Would you be willing to add CEFs to your portfolio if they would have historically *decreased* volatility by 2% while having increased your income expectations by 41%? True, the expense ratios would be significantly higher, but because with CEFs leverage trumps expenses as a driver of total returns (again, see our study here), your total return would have also been higher (by 15.3% annualized). Bear in mind, of course, that in down markets the leverage would work the other way, magnifying losses to the downside. And investors would need to be able and willing to hold on to the entire portfolio during rough patches in order to capture its potential total return, income, and diversification benefits.

**Caveats and Conclusion**

Our purpose here has been to present one example of how adding an allocation to CEFs to an existing portfolio could affect the portfolio's total returns, volatility, expenses, and income generation. We attempted to create reasonable portfolios for comparison and aligned the metrics for distribution rates to make for better apples-to-apples comparison between mutual funds and CEFs. Total returns, standard deviations, and expense ratios are backward-looking metrics, whereas the distribution rate is what investors can reasonably expect in the near-term future. Obviously, our results would have been different if we had picked different mixes of funds. There are a lot of caveats, but we don't believe they erode the outcome. Investors with tolerable risk thresholds could benefit from adding reasonable amounts of CEFs to their portfolios. In our representative examples, adding leveraged closed-end funds to the portfolios actually lowered the volatility of the overall portfolio.

Every data point in our example is reflective of one period in time and may not be replicable. If we took this study out five and 10 years, it is possible (and highly probable) that the higher share price volatility of the closed-end funds over those time periods would increase the volatility of the combined portfolio. All this means is that we have ideas for future time periods. Again, our representative portfolios are indicative of past performance over one period of time.

To assert that CEFs are too complex and volatile to include in individual investors' portfolios is a disservice to both CEFs and individual investors. As we've attempted to illustrate, inserting leveraged, income-focused CEFs into a broader portfolio can significantly increase the income component of that portfolio's total return with a marginal increase in expected standard deviation. As one reader recently commented: "I have found that CEFs can add extra value to your portfolios and allow a further level of diversification and professional management to your portfolio." For investors willing to understand the vehicle and accept its potential risks, we couldn't agree more.

*Note: We changed this article to reflect portfolio-based statistics when referring to total portfolio performance. The initial version of the article simply referenced averages derived from the individual funds' metrics. The initial version of the article referenced Vanguard Total International Stock Index Admiral VTIAX, which we replaced with Vanguard Total International Stock Index Investor VGTSX because the latter fund has been around longer; this replacement did not materially change our results because the two funds have largely identical total returns, standard deviations, expense ratios, and expected distribution rates.*