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SMART INSIGHTS FROM PROFESSIONAL ADVISERS

The Case for Closed-End Funds

The "orphan children" of the fund management industry, some CEFs are worth considering in a diversified portfolio.

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Amidst the excess of investment vehicles today, closed-end funds (CEFs) have lost their allure with many investors, yet can present very good opportunities for particular asset classes, namely fixed income. While CEFs may not be right for every investor, there are potential opportunities to explore when designing a portfolio.

See Also: 7 Worst Mistakes Investors Will Make In This Market

Throughout its history, the fund management industry has been creative at introducing pooled investment vehicles in pursuit of its primary goal—gathering assets. Today, exchange-traded funds (ETFs) are all the rage and are taking share from commonly known open-end mutual funds, which achieved their prime from the post-WWII era through the 1990s. As for CEFs, their start dates back to the late 1800s when money managers created trusts or corporate equivalents that took stakes in a variety of companies.

CEFs have a well-defined strategy and a manager whose job is to seek the best return possible given the strategy. Unlike open-end mutual funds, which are called open because shares issued can fluctuate daily on the basis of investors redeeming or adding capital to the fund, CEF shares are fixed. While an investor can redeem capital from a mutual fund at the net asset value (NAV) of the fund at the daily closing market prices, CEF investors must trade the CEF shares on an exchange to invest or redeem their capital. As a result, CEF shares can trade at a discount or a premium to the NAV of the fund. Throughout history, CEFs have traded at a small, single-digit-percentage discount to their NAVs. A discount can be justified for the following reasons:

1) illiquidity of trading the shares;

2) bid-ask spreads that are too large;

3) captive management fees; and

4) presence of financial leverage.

However, recently the average industry CEFs discount has widened to nearly 9%. In other words, if the markets shut down the CEF industry tomorrow, investors would make 9% returns (less the costs of closing all positions).

In the fixed income realm of CEFs, credit analysis is the key. Investors and their advisers need to look for well-trained managers with a discerning eye, who can evaluate balance sheet and cash flow analysis when picking one bond versus another.

We can already see the result today in the high-yield fixed-income markets, where well-thought-out research can help a manager avoid the near-certain bankruptcies of some companies in the energy markets. Additionally, since CEFs do not need to manage inflows and outflows of assets, they can generally remain fully invested at all times. This helps investors in CEFs avoid redemption risk and creates more efficient management than open-end funds, which must manage continuous cash flows from investors in the fund.

With "safe-haven" investments such as U.S. Treasuries posting low rates of return, CEFs can be structured to provide attractive monthly or quarterly income for retirees and other investors seeking yields. Just be aware that CEFs are more volatile than traditional fixed-income securities because of the leverage mentioned above. Additionally, when the market turns against dividend-paying securities, CEFs can be negatively impacted.

At Barron's 2016 Roundtable, noted bond expert Jeffrey Gundlach of DoubleLine Capital made the case for deeply discounted closed-end bond funds: "If the [Standard & Poor's 500-stock index] rises 10%, closed-ends could return 20%," he said. "If the stock market falls 30%, a decline is already priced into these funds."

For investors with at least a five-year time horizon and the ability to ride out volatility, picking CEFs from well-respected managers is worth considering in a diversified portfolio. Buying low at a discount with cash flow potential over the long term is a compelling choice in today's low-rate market environment.

See Also: 6 Worst Vanguard Funds for Your Money

Robert Altshuler, JD CLU CHFC, founder of PlanningCore Wealth Advisors, LLC, provides investment and estate strategies to entrepreneurs, executives and affluent families in Phoenix, Arizona.

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