How Closed-End Funds Can Help You Differentiate Your Firm and Attract and Retain Clients
By taking advantage of a wide range of investment strategies, closed-end funds can provide low-correlated distribution streams for income-focused investors
If you have clients—especially retirees and pre-retirees—who are looking to increase portfolio income, consider adding closed-end funds (CEFs) to your toolkit. CEFs can provide a reliable income stream that is often tax-advantaged.
CEFs offer additional benefits as well. Due to their unique structure, CEFs can invest in less liquid asset classes and use leverage in an effort to increase income and returns.
Even though CEFs have been traded for almost a century in the U.S., they can be misunderstood by many advisors. However, those advisors who invest a bit of time researching and learning about CEFs may find that CEFs are not as complex as they initially thought and that a CEF’s unique structure can contribute to an already diversified portfolio.
This whitepaper provides information about how CEFs provide potentially higher income and returns and how incorporating the funds into a practice may help advisors differentiate their firm, attract, and retain clients.
What Makes a Closed-End Fund Unique?
CEFs issue a set number of shares to investors at the fund’s launch (IPO) and thereafter, typically do not issue any additional shares for sale, while mutual funds sell an unlimited number of shares.
After the IPO, CEF shares trade on an exchange like a stock or ETF rather than directly with the sponsoring fund family. Therefore, no new investment capital flows into a CEF, except in a few circumstances including secondary offerings or rights offerings.
So while mutual fund managers must be concerned with having enough cash to honor redemptions from shareholders, CEF managers can stay fully invested rather than having to hold cash to fund liquidations that can dilute performance.
“Since CEFs do not have to maintain cash reserves to meet shareholder redemptions, portfolio managers can invest their best ideas for a full market cycle,” explains Dave Lamb, Managing Director in Nuveen’s Global Product Group. “Managers aren’t forced to buy or sell when they don’t want to and can take advantage of inefficiencies in the market. There’s no cash drag in the portfolio.”
Unlike mutual funds in which orders are placed at the close of business based on the closing net asset value (NAV), CEF shareholders sell or redeem shares to other shareholders on an exchange such as the NYSE or NASDAQ at the market price per share during the trading day. The share price will fluctuate according to market supply and demand and the changing values of securities in the CEF. This means that a CEF can be priced at a premium—the price of a share is above the NAV—or at a discount to NAV.
“CEFs can trade away from NAV, but that provides opportunities to buy a fund at a discount,” says Lamb. “And, since CEFs are for long-term investments, the entry point is less relevant to overall return.”
How Closed-End Funds Provide Income Diversification
CEFs are designed to provide monthly or quarterly distributions for a steady income stream, even from assets not typically associated with income, such as equities.
Although advisors tend to associate CEFs with municipal bonds, CEFs are available in a wide array of asset classes—some otherwise only available to institutional investors—including high-yield bonds, taxable fixed income, senior loans, preferred securities, equities and convertibles, as well as covered call overlay strategies and private equity. For this reason, CEFs can be a diversifier for an income portfolio.
“CEFs allow managers to hold on to a potentially more stable portfolio and not have to deploy assets at the top of the market or fund liquidations at the bottom of the market. They can take a long-term view and be opportunistic buyers”, says Lamb, which enables managers to invest in less liquid names.
Most CEFs are organized as regulated investment companies (RICs). An RIC must distribute 90% of its investment company taxable income for “pass through” tax treatment. In addition, RICs must distribute 98% of taxable income and capital gains to avoid a 4% excise tax.
Leverage Can Enhance Closed-End Fund Returns
CEFs can use leverage in ways that mutual funds or ETFs can’t. To create leverage, a CEF raises capital by borrowing at short-term interest rates. These rates are typically pegged to LIBOR, the Fed funds rate, or for municipal funds – the SIFMA index. LIBOR (London Interbank Offered Rate) is the average interest rate at which major global banks borrow from one another while the Fed funds rate is set by the U.S. Federal Reserve. The SIFMA Index, set by Bloomberg weekly, is the average yield of municipal variable rate demand notes (VRDN).
CEFs use the proceeds to make additional investments for the portfolio. A CEF can also leverage itself by issuing senior securities (preferred shares of the fund) that pay variable or fixed dividends at short-term rates. Holding certain investments within the portfolio – portfolio leverage – is another strategy.
While it’s true that leverage can increase volatility and risk—and magnify returns both negatively or positively—CEFs that use leverage have generally had higher returns historically than unleveraged CEFs.
However, CEFs don’t use leverage for short-term, tactical strategies. Instead, CEFs take advantage of spreads by borrowing at short-term interest rates and investing the proceeds in longer-term securities that have higher rates of return. For CEFs that use leverage—and not all CEFs do—the steeper the yield curve, the better. But even if the yield curve flattens, leverage can contribute positively to fund earnings.
“Once advisors understand how we leverage asset classes that show persistent upward sloping yield curves or persistent credit spreads, they understand how we are able to deliver higher returns over time,” notes Lamb.
That said, CEFs are not as highly leveraged as some other investment vehicles. The Investment Company Act of 1940 limits the amount of leverage a CEF can use to a maximum of 50% for preferred shares and 33.3% for debt.
Getting Started with Closed-End Funds
Advisors who use CEFs tend to have more loyal clients and more assets under management. According to Nuveen’s 2018 national research study of financial advisors’ use of CEFs, advisors who use CEFs are more than twice as likely as advisors who don’t use CEFs to retain clients for 15 years or more. While 24% of advisors not using CEFs have more than $100 million AUM, that percentage soars to 42% for those advisors using CEFs.
CEFs can be more complex than mutual funds or ETFs, but those advisors who understand the underlying investment strategy by educating themselves about CEFs can differentiate their firm from competitors, suggests Lamb. And although the NAV of a CEF will react fairly predictably, advisors will also need to be prepared for fluctuating share prices. One source of information is the Education Center at CEFConnect.com.
To get started, consider an unleveraged CEF that will tend to be more predictable and have fewer variables impacting returns but that will still take advantage of the structural benefits of a CEF, advises Lamb.
Consider augmenting a client’s municipal bond allocation with CEFs. “We believe that CEFs have a place in a client’s diversified portfolio, especially for those clients with income needs,” says Lamb. “Advisors have many choices of CEFs, and most of those deliver attractive levels of income, either monthly or quarterly.”
While retirees are a great target market since they are often in need of income, other investors are also looking for yield in a low interest rate environment.
CEFs can complement a well-diversified portfolio while potentially enhancing income and cash flows. CEFs can create a reliable income stream that is often tax-advantaged, invest in less liquid asset classes, and use leverage to potentially increase income and returns.
As investment advice becomes commoditized and fees are compressed, CEFs can really differentiate your firm and help you address client income needs over the long-term.
For more information on how to navigate closed-end funds, contact Nuveen at 800.752.8700.
Risks and disclosures
Leverage typically magnifies the total return of a fund’s portfolio, whether that return is positive or negative, and creates an opportunity for increased common share net income as well as higher volatility of net asset value, market price, and distributions. There is no assurance that a fund’s leveraging strategy will be successful.
It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund’s investment objective will be achieved. Closed-end fund shares may frequently trade at a discount or premium to their net asset value (NAV). When sold, shares may be worth more or less than the purchase price or the net asset value. It is important to consider the objectives, risks, charges and expenses of any fund investing. For this and other information that should be read carefully, please view the prospectus or other current fund information provided by the fund’s sponsor. Open-end mutual funds and CEFs are different types of investment vehicles with different expense structures and different inflows/outflows and distribution requirements. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Closed-end fund historical distribution sources have included net investment income, realized gains, and return of capital.
Nuveen Securities, LLC, member FINRA and SIPC
Nuveen is a premier global investment manager that has been helping clients meet their goals for more than 100 years.