For those investors inclined to assume a bit more risk in exchange for the chance at a higher return, closed end funds (CEFs) can provide both yield enhancement and exposure to more exotic strategies. However, I think it’s important to point out that from a management perspective, the differences between a CEF comes in stark contrast to open end funds (OEFs) for a few specific reasons.
First, for all intents and purposes the fund’s capital is permanent; so managers know they will never find themselves in the awkward position of deciding which assets to liquidate to meet fund redemptions. Secondly, they can strategically use leverage to capitalize on unique opportunities within the market. They essentially “create” capital within their fund to exploit a new investment theme, which is usually the opposite of what happens when managing an OEF strategy. In an open fund format, capital is often ripped from your grasp at exactly the wrong time as individual investors pull back on the risk lever.
As a result of these structural advantages, CEFs can utilize a more exotic or esoteric mix of assets to boost yield or capital appreciation prospects. Envision it this way – an OEF will never be able to own enough of a potentially attractive illiquid issue to make a difference because of the redemption risk. As a result, these positions are kept small as a percentage of total assets.
Historically, CEFs have been able to leverage illiquid securities, issues with small floats, or more concentrated and active allocation strategies to capitalize on attractive valuations. Furthermore, CEFs can more freely use derivatives to control the interest rate or credit risk of the fund’s cash-settlement bonds.
Yet there are a few tips that I think traditional portfolio architects should keep in mind when dabbling in CEFs. Primarily, it’s not all about asset allocation as it is in traditional portfolio management. A good example is our Dynamic CEF Income Portfolio’s heavy tilt toward credit CEFs instead of using traditional equity positions to balance out the inflationary side of the portfolio. In fact, our asset allocation is 71% fixed income, 22% equities, 7% alternatives, and currently 0% cash.
We believe this structure accounts for a more effective yield generator and also allows the portfolio to keep pace in a rising market environment despite low equity exposure. If I were to mirror the asset allocation of our more conservative Strategic Income Portfolio at nearly 35% equities, the CEF portfolio would exhibit more volatility and also sport a lower yield.
Another important consideration when constructing an all-CEF portfolio is to keep the number of positions relatively small. We typically target between 10-15 funds at any given time. The purpose of this is to actually realize the benefit that each manager might bring to the table rather than over diversifying.
For example, if you own 3-5 different preferred stock CEFs, one manager might dial in just the right mix of assets in the prevailing market environment. This will then increase the chances that the other managers will underperform, thereby dragging down your returns and reverting them back toward the mean.
For this very reason, I am not a fan of indexing a large swath of closed-end funds, such as the PowerShares CEF Income Composite ETF (NYSE:PCEF) as a surrogate for an effectively managed individual CEF portfolio. By their nature, CEFs are inherently diversified through their underlying holdings, so 15 positions are more than representative of a well-diversified portfolio.
Instead, select one or at most two funds for each category or sector. That way you’re able to effectively slice and dice your portfolio to make future sector or asset allocation changes easy and intuitive. You won’t ever be forced to make the difficult decision on which preferred stock fund to keep and which one to dump.
In addition, investors need to keep in mind that ALL CEFs are risk assets, even if their underlying portfolio has quality holdings. For instance, even though the NAV of a fund made up of U.S. Treasury bonds will rise in the midst of a wave of volatility in risk assets, the fund’s market prices can and will get caught up in the downward stampede.
Furthermore, I think the benefits of owning CEFs are better realized through fixed-income and alternative asset management. More specifically, the pure size and breadth of the bond market creates the potential for alpha to be unlocked through dislocations and individual security selection. The equity universe has simply become too overly correlated, so it doesn’t make sense to pay a relatively high fee for a CEF that invests in broad-based stock exposure. A low cost and diversified exchange-traded fund is a much better option for the bulk of your stock allocation.
Finally, the key to managing a CEF portfolio effectively over time comes down to due diligence. The ability to identify new trends and snuff out underperforming funds will play a pivotal roll in adapting to changes in the market.
For clients in our Dynamic CEF Income Portfolio, the weighted average effective yield of the strategy rests at 7.996%, and I’m even more pleased to report that the underlying yield is even higher as a result of modest fund distribution policies. Moreover, I think a reasonable expectation for total return in a good market year lies in the 12-15% range. However, like all high risk/high return strategies, there will be a few bumps along the way. Just remember to use these dislocations in price or net asset value to your advantage whenever possible.