Five reasons for income investors to consider closed-end funds

Closed-end funds have been delivering income for decades. Designed to seek regular, and often tax-advantaged distributions, they are one of the most efficient vehicles for building, growing and sustaining retirement income (although of course such income cannot be guaranteed). CEFs can offer the benefits of diversification by providing exposure to an array of potentially income-enhancing asset classes, including those that may be difficult to access using other vehicles. They are positioned to generate income differently than open-end mutual funds and exchange-traded funds (ETFs), thanks to some key structural differences and features that set them apart:

1. More fully invested portfolios

Unlike mutual fund managers who must juggle 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 sell (redeem) shares. This is because closed-end funds trade on an exchange and investors who want to buy or sell their shares do so via the exchange, not the fund sponsor. Therefore, the fund manager can remain focused on the fund’s investment strategy because no cash is flowing into or out of the portfolio.

2. The Potential to Buy at a Discount

Because CEF shares trade on exchanges, and their prices are determined by market demand and supply, shares commonly trade at prices that differ from their net asset values. While CEFs are designed for long-term investors, not frequent traders, investors can still take advantage of a closed-end fund’s periodic discount as an additional opportunity to potentially bolster income portfolio returns.

3. The Ability to Invest in Less Liquid Securities

Open-end mutual funds’ liquidity needs can make it difficult or impossible for them to invest in less liquid or smaller capitalization securities and markets and private placements. Closed-end funds can more easily invest in specialized areas like these, thanks to their relatively stable asset bases. Regardless of the trading volume or market price fluctuations in these areas, closed-end fund managers are not typically 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 somewhere at rising prices. A relatively stable asset base also makes it easier to take advantage of approaches such as leverage, long/short strategies, option overlays and managed futures—which may have the potential to enhance the funds’ diversification, return and cash flow.

4. Leverage to Magnify Returns

Closed-end funds may borrow money or issue senior securities (preferred stock or debentures) to increase, or “leverage,” their investment exposure. This, in turn, offers the opportunity to enhance portfolio income and performance. If the underlying portfolio return is positive, a leveraged fund typically will deliver higher shareholder returns and income than an unleveraged fund with the same strategy, simply because more assets are at work for the investor. Conversely, if the underlying portfolio return is negative, a leveraged fund will suffer greater losses than an unleveraged version. In other words, use of leverage increases the likelihood of share price volatility and market risk. Time, however, can be a friend of the income investor. Over longer periods, leverage has in many cases historically delivered incremental income that has more than compensated for its associated cost and added volatility.

5. Managed Distribution Policies

The unique structure of CEFs has historically provided smoother distributions from a wide range of asset strategies through a managed distribution program. A managed distribution program allows a fund to pay actual and expected capital gains throughout the year – not just in a single year-end distribution. This approach can be particularly helpful to increase diversification and income potential from investments in equities and other strategies with historically high appreciation potential rather than interest income. A managed distribution program essentially represents a CEF’s commitment to seek to provide shareholders with a predictable, but not assured, level of cash flow.

When comparing closed-end funds to traditional mutual 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.