by Cynthia Harrington CFA
In contrast to the thousands of planners recommending the $7 trillion open-ended mutual fund market, advisors that use closed-end funds make up a small community.
But with the bloodbath in equity markets over the past two years, there’s renewed focus on the offerings of the $123 billion closed-end fund industry.
One reason is that bond funds are in demand and 62 percent of closed-end funds are bond funds. Of the 36 newly issued closed-end funds in 2001, 33 of them were bond funds. One of the largest closed-end fund managers is Nuveen & Co. Nuveen just closed an offer of eight new municipal funds, along with MuniPreferred shares in the funds. Total capital raised was $1.5 billion. Closed-end funds invest in bonds and stocks, as well as specific market sectors or security types.
"The bursting market bubble and the flight to income refocused attention on the closed-end structure," said Brian Smith, executive director, Closed End Fund Association, Kansas City, Mo. "We’re also seeing significant new flows into the fixed-income funds using leverage to enhance yields."
The use of leverage is one way in which closed-end funds differ from their open-ended counterparts. In the annual UBS Warburg closed-end fund review, the number one ranked leveraged municipal fund, Eaton Vance Municipal Income Trust, yielded 6.4 percent while the number one non-leveraged fund, the Nuveen Municipal Value Fund, yielded 5.4 percent.
Closed ends are managed portfolios of stocks and bonds but the number of shares is fixed once the initial offer period is over. The shares trade on a public exchange. Closed ends are taxed the same as open ended, passing through tax liability to shareholders. They also are required to distribute income and capital gains annually.
The controlled universe of shares works to a closed-end fund’s advantage in two ways. First, the pool of capital is predictable so the portfolio managers’ and traders’ decisions can be focused on longer-term investing. Second, the fund does not need to worry about redemptions. Managers don’t have to sell holdings to satisfy redemption requests. "Closed-end funds can take a more conservative approach to investing," said Smith. "That kept closed ends out of the speculative areas of the market in the 1990s, and the last two years closed ends’ performance has not suffered from the need to sell out of holdings as investors liquidated funds."
Trading on a public exchange is what causes the biggest disadvantage to closed-end funds for most advisors. Because the publicly trading shares are priced according to supply and demand, they can be priced differently than the net asset value of the fund. Mark H. Kaizerman CFP, CPA, PFS, ChFC Kaizerman & Associates, Natick, Mass., doesn’t use closed ends at all because of the volatility of the market prices. "They trade too much like a security," said Kaizerman. "We don’t used closed ends for the same reason we don’t use individual stocks, because of the volatility."
Smith conceded that while closed ends are back in style, they were decidedly unfashionable during the 1990s. "There was a chill in the water for closed-end funds for a long time before our recent surge," said Smith. "Funds sold at wide discounts to NAV. The new issue market dried up because of shareholder insistence on guidelines to manage the discounts."
Exchange-traded funds are often lumped in with closed-end funds because both trade on public exchanges. ETFs differ in that they issue and redeem shares as needed and so do not represent a set pool of capital. That fact is one reason behind the delays in issuing actively traded ETFs. All are currently passively indexed funds.
The fact that shares in closed ends can trade at a premium or discount forces another step in the process of due diligence. Spreads widen on equity funds during bear markets and narrow during bull markets. Bond fund spreads move in opposite directions than interest rates. Rising interest rates widen discounts; falling rates can drive prices to a premium. Take high yield closed ends for instance. Last year the premium for such funds was 15 percent, compared to an average three-year premium of 3.5 percent.
"It’s actually easier to talk about when we would never use them than when we do use them," said Ray Ferrara, CFP, ProVise Management Group LLC, Clearwater, Fla. "We would never buy one when it was selling at a premium."
George Cole Scott III, president and portfolio manager, Closed End Fund Advisors, Richmond, Va., likes closed-end funds specifically because of the pricing differential. "The discount gives us a distinct advantage over open-ended funds," he said. "We like buying a dollar worth of assets for 80 cents."
Closed End Fund Advisors invests at least 75 percent of client assets in closed-end funds, with the remaining quarter in special situations depending on market conditions. They follow a tactical asset allocation model, moving assets to those classes they believe will outperform in the near future. They work on a discretionary basis with clients, and have commission- and fee-sharing arrangements with advisors that place clients’ assets under their management.
Ferrara recognizes the trading opportunities in closed-end funds as well. They buy closed-end funds only for aggressive investors looking for Las Vegas-type volatility. Even then, they commit a small percentage of assets to such trading. "We take sector bets in closed-end funds," he explained. "Six months ago emerging markets fit the strategy. We looked at the overvalued dollar and knew that international and emerging markets were likely to do well. Emerging markets in particular had deep discounts."
"But it takes lots of fortitude to buy these funds while the discount is steep," said Ferrara. "There are a lot more people and lots of smart money that think you’re wrong than think you’re right."
Another advantage of closed-end funds is age of industry. The first of this type was sold to the public in 1893, and several have management and performance histories over 50 years old.
