Registered Rep.: Are advisors using closed-end funds correctly?
Patrick Galley: In my opinion, they should be looking at them on a total return basis, but I think there a lot of investors out there that look at them just on a yield basis. They'll bid up closed-end funds pretty high based off the yield, but I think that's a recipe for disaster at some point in the future. As long as everything is going well, that works. But I think there's a lot of downside risk that you're taking by investing just off of yield.
RR: How did closed-end funds respond to the volatility in the markets at the beginning of August?
PG: With the fear that ensued, that uncertainty spooked investors. There are no outflows in closed-end funds, but investors that are looking to get out have to sell them, and that selling pressure pushes discounts wider. For all closed-end funds, the average discounts were at 2 percent on June 30, and they got to almost 9 percent on Aug. 8. As of Aug. 15, they were 3.8 percent on average.
RR: Do you expect that widening to continue?
PG: At some point, the fear will subside. I think equities are still going to have fear associated with them, given investors were just burned recently. So that means a lot of closed-end funds that are income-producing closed-end funds will definitely be a place investors will be going to, and with the Fed saying they're going to keep short-term rates low for the next couple of years, that also makes a strong case for closed-end funds. I wouldn't be surprised if we get below that 2 percent average discount when that fear subsides.
RR: How do closed-ends behave differently than open-end mutual funds in times of volatility?
PG: In times of volatility, they definitely are more volatile than open-end mutual funds because of the discount volatility. When the fear increases, there are more sellers than buyers. The average daily volume is typically around $400-$500 million in taxable closed-end funds. The average volume peak on Aug. 8 was almost $1.5 billion, and most of that is due to sellers.
RR: Any advice on how advisors should play closed-end funds right now?
PG: My advice would be to have dry powder on the sidelines, and that dry powder could be in the form of cash or other investments such as ETFs and open-end funds. You don't want to be all-in on closed-end funds. And when volatility increases and fear increases, that's the time to buy, not sell. So you're using that dry powder to put back into closed-end funds.