And what the CEF industry can do about it.
During the past decade, U.S. open-end fund assets under management have grown by 160%. Meanwhile, exchange-traded fund net assets grew more than 900%. Closed-end funds, on the other hand, grew a paltry 54%. Even with historically low interest rates and a tremendous marketwide thirst for income, CEFs still make up less than 3% of market share in U.S. fund assets.
Ask any CEF sponsor what the biggest problem facing the industry is and he will likely point to investor education. If only investors knew more about closed-end funds and their wonderful income-generating properties, the narrative goes, then CEFs would be more popular. After all, CEFs are complex investment vehicles; if investors just understood them, they would be more likely to own a couple in their portfolios, right?
This view is misguided. Sure, CEFs are complex, and investors who are lured in by the promise of "high income" are doing themselves a disservice if they don't understand the risks. But complexity on its own cannot explain CEFs' lack of popularity. Equities and ETFs1 can be more complex than CEFs, and both are fairly popular. Besides, it's not unusual to see investors of all stripes buy things they don't understand in droves. Collateralized debt obligations circa 2006 didn't have an education problem.
The fact is that CEFs as they exist now will never become mainstream investments. Education can go only so far. The issue is not that CEFs are hard to understand--it's that they are often not worth understanding. To be sure, investors with well-rounded tool kits might want keep some basic CEF knowledge in the back of their minds, should they come across an occasional bargain. But for the most part, CEFs will forever remain a niche market unless the industry makes some significant changes.
So if not for education, what's stopping CEFs from hitting the mainstream?
Problem 1: CEFs Are Difficult to Launch
ETF sponsors have it comparatively easy. They can launch hundreds of ETFs at their convenience; some of them will catch on and raise billions in assets, while others will simply fail and liquidate. In contrast, CEFs conduct an initial public offering, where they are forced to raise most of their capital over a short period of time. A bad IPO means that the fund will either be stuck with a small asset base or eventually merged into another fund.
The real difficulty in raising capital for a CEF is that it's almost always a bad deal for investors. When a new CEF launches, the underwriter takes a cut of the capital raised, typically 5%. For instance, if a new fund issues 10 million shares at $10.00 per share, it starts off with a net asset value of $9.50. Investors pay a 5% premium on day one for the right to buy a fund with no track record. In other words, a strategy has to be overvalued--by definition--for it to be launched as a closed-end fund. Most investors aren't that naive, especially if similar funds are trading at discounts. Hence the CEF adage: Closed-end fund IPOs aren't bought, they're sold.
Even when CEFs are "hot" and trading at rich valuations, issuances tend to be unspectacular. As the broader CEF universe traded at a modest discount throughout 2011, the industry raised $5.9 billion by launching 17 new funds. In 2012, CEFs as a whole traded even closer to their NAVs and saw new 22 launches for nearly $12 billion in assets. Then in the first six months of 2013 (before the Fed hinted at tapering their bond-buying program), 19 CEF launches raised $13 billion. For the 2.5-year hot streak, when CEFs were at the peak of their recent popularity, CEF net assets grew only 18%.2 This sort of growth is fine, but it's disappointing considering that this is the best CEFs have to offer. In comparison, ETFs grew 53%, and open-end funds grew 26% over that period. There are also signs of a slowdown for CEFs. In the past 11 months, the industry managed to launch only seven new funds for $2.4 billion in assets.