We look at the best bank-loan funds among ETFs, closed-end funds, and mutual funds.
Earlier this week, I wrote an article titled "Should You Consider Floating-Rate Bank Loans Today?" in which I outlined the reasons investors might consider--and why many are flocking to--bank-loan funds in the current environment. Today, I'm going to highlight some of our favorite funds in the sector.
Selecting a Vehicle
There are a number of mutual funds, closed-end funds, and exchange-traded funds that invest in bank loans. There are pros and cons to investing in each fund format that are important to be aware of.
Closed-end funds offer the advantage of having a fixed asset base. Having a committed pool of capital means the portfolio manager doesn't have to worry about being forced to buy or sell securities to manage the flow of money into and out of the fund. This attribute can be particularly advantageous in less liquid sectors like bank loans, which can be prone to panic selling by investors. The drawback of having a fixed asset base is that CEFs can and do trade at regular and sometimes persistent premiums or discounts to their net asset values. CEFs may also make use of leverage in an effort to enhance returns. Of course, leverage cuts both ways and typically will increase volatility.
Exchange-traded funds are a relatively new vehicle for gaining exposure to bank loans. The oldest fund in the category, PowerShares Senior Loan Portfolio BKLN, was launched just two years ago. ETFs have the advantage of offering below-average fees and intraday liquidity and tend to trade near net asset value. ETF investors have the choice between passive or active strategies in the ETF wrapper. And for investors who value intraday liquidity, the current crop of bank-loan ETFs has greater trading volumes, on average, than its CEF peer group
Relative to CEFs and ETFs, mutual funds have the advantage of transacting at net asset value. Investors who make regular contributions to their portfolio can often avoid paying commissions by investing in mutual funds through a platform with no transaction fees. Most bank-loan mutual funds do not employ leverage.
A comparison of mutual fund and CEF bank-loan category returns sheds some light on the effect of CEFs' use of leverage. As seen in the table below, the CEFs in the bank-loan category had higher average returns over trailing three-, five-, and 10-year periods. However, these returns came at the cost of far greater volatility. The volatility of returns for CEFs in the bank-loan category was 50%-75% higher than the average mutual fund in the category. Morningstar's risk-adjusted return measure provides a better basis of comparison between the two vehicles. This calculation removes the effect of leverage, therefore allowing direct comparisons between leveraged and nonleveraged funds. CEFs in the bank-loan category underperformed their mutual fund peers over the trailing five- and 10-year periods, on average.