By Anne W. Kritzmire
There’s nothing like eight years of ultra-low interest rates to bring the importance of income investing into focus. With traditionally “safe” options like certificates of deposit, money market funds and passbook savings accounts offering microscopic yields, investors—especially those nearing retirement—have been forced to look beyond these now seemingly “quaint” vehicles in searching for yield.
Even as rates slowly increase, it could be years before rates reach a historically “normal” level. In the bigger picture, investors and their financial advisors must also consider the implications of retirement-related policy and demographic changes, including longer life expectancies and higher costs of health care, and take a thorough look at how best to construct an investment strategy with a significant income engine.
One corner of the market that has inherent income-producing advantages across most investment strategies—and has been delivering diversified income for decades—is closed-end funds (CEFs). Closed-end funds are one of the most efficient investments for building, growing and sustaining the ongoing income investor’s needs in retirement.
Closed-end funds are designed for smooth, regular, and often tax-efficient cash flow, making them an attractive vehicle for income, though such income cannot be guaranteed. Key structural differences can position them to generate income differently than their open-end mutual fund cousins or exchange-traded funds (ETFs). Typically actively managed, CEFs can offer the benefits of diversification while also providing broad exposure to an array of asset classes and strategies that can enhance cash flow.
Efficient Portfolio Management
Unlike mutual fund managers who face constant inflows and outflows of cash, closed-end-fund portfolio managers can put capital to work in a long-term strategy, without worrying whether their fund will have enough liquidity to pay back investors who suddenly sell (redeem) shares. Although fund shares trade actively, the fund manager can remain focused on the investment strategy because no assets are flowing into or out of the portfolio. The share price of closed-end funds is determined by market demand and supply, so CEF shares commonly trade at prices that differ from their net asset value. While CEFs are designed for long-term investors and not frequent traders, taking advantage of a closed-end fund’s periodic discount may present an additional opportunity to add to one’s income portfolio.
Investing in Less Liquid Securities
Stable asset bases also make the closed-end-fund structure advantageous for investing in specialized areas such as less liquid or smaller-capitalization securities and markets, real estate, and private placements. Regardless of the trading volume or market-price fluctuations in those areas, closed-end-fund managers are never forced to sell securities in a declining market to meet redemptions. Conversely, in a bull market, closed-end fund managers aren't inundated with new cash they must invest at rising prices. Stable asset bases also make leverage, long/short strategies, option overlays and managed futures more readily available. With the potential to help mitigate liquidity risk, these in effect may enhance diversification, potential return and cash flow of CEFs.
While these alternative asset classes and strategies can be complex, less illiquid and more difficult to value, with higher volatility and potential risk of loss than traditional investments, they are more easily accessible, tradable and more diversified in the form of CEF shares. Open-end mutual funds can invest only 15 percent of their portfolios in illiquid securities. Closed-end funds do not have this restriction, making them a more attractive vehicle for retail investors interested in alternative strategies.
Designed for Income and Cash Flow
One key source of a CEF’s income generation is its ability to invest using various forms of “leverage.” Closed-end funds may issue senior securities (preferred stock or debentures) or borrow money to increase, or leverage, their investment positions. This, in turn, offers the opportunity to enhance yield and provide investors with attractive performance.
The primary result of using leverage is the potential for enhanced portfolio income and performance: if the underlying portfolio return is positive, a leveraged fund typically will have higher shareholder returns and income than an unleveraged fund with the same strategy, because more assets are at work for the investor. Conversely, if the underlying portfolio return is negative, a leveraged version will have greater losses than an unleveraged version. Time, however, is important and can be the friend of the income investor. Over a longer period, such as three or five years, leverage has historically delivered incremental income that more than compensated for the associated cost and added volatility. The use of leverage, of course, increases the likelihood of share-price volatility and market risk.
Managed Distribution Policy
Because most are investment companies, CEFs make distributions of ordinary income and net-realized capital gains to investors. A managed distribution program allows a fund to pay actual and expected capital gains throughout the year—not just in a single December distribution. This can be particularly helpful to offer both diversification and high cash-flow potential from equities and other strategies that have historically high appreciation potential. A managed distribution program is essentially a CEF’s commitment to shareholders to provide a predictable, but not assured, level of cash flow. Managed distribution policies also generally serve to reduce a discount between a closed-end fund’s market price and its NAV per share.
When looking at traditional mutual funds and closed-end funds, keep in mind that distribution rates and yields are different measures. A mutual fund's yield shows its interest and dividend income expressed as a percentage of the fund's current share price. The distribution rate of a closed-end fund might also include a return of capital, which can represent the fund’s original capital or additional capital due to unrealized gains in the fund’s portfolio.
An Important Consideration for Income Investors
Because closed-end funds are structured and managed with the goal of delivering regular cash flow to investors, we believe that every advisor must understand the benefits of these funds, how to properly use them and potential risks, as nothing in investing is guaranteed. CEFs can provide distinct income opportunities, coupled with the benefits of diversification and active management. As the U.S. retirement landscape continues to evolve, and the need for income during retirement increases—CEFs should come into sharper focus as an essential tool for many investors and their advisors.
Anne W. Kritzmire is the managing director of closed-end funds at Nuveen.