John Cole Scott believes that sometimes it would be easier to squeeze blood from a stone than provide his clients with the retirement income they demand from their assets.
One client, for example, recently told the adviser that he needs $3,000 in monthly income from his $500,000 in retirement savings — the equivalent of a 7.2% withdrawal rate.
[More: Closed-end funds for retirement income: Why anxious retirees should consider closed-end funds]
“That's not so unusual anymore,” said Mr. Scott, a portfolio manager at Closed-End Fund Advisors Inc., which manages about $760 million in assets.
To help meet clients' income needs, Mr. Scott is among a group of advisers that rely on closed-end funds. Like mutual funds and exchange-traded funds, closed-end funds contain a mix of assets, usually equities, municipal bonds or taxable bonds. Unlike mutual funds, however, closed-end funds consist of a fixed basket of assets and a fixed number of shares that are launched via an initial public offering and then trade on an exchange.
Pricing anomalies in closed-end funds, however, tend to increase yields to investors, often making them a better source of income for some people than other kinds of investments.
After their IPOs, most closed-end funds over the past decade have traded at a median discount of about 4.4% to their net asset value, according to Maury Fertig, co-founder and chief investment officer of Relative Value Partners LLC, which manages $540 million in assets and specializes in closed-end funds.
He attributes the discount to investor psychology.
“The retail investor typically mismanages risk, buying and selling at the wrong time,” said Mr. Fertig, who estimates that about 85% of closed-end funds are owned by individual investors or by institutions on their behalf.
Fixed-income closed-end funds typically decline when equity markets go down, “and there is no rational reason for that,” Mr. Fertig said.
Investors who buy closed-end funds at a discount, however, can benefit from the irrational pricing because distributions are based on a fund's net asset value per share, not market price. For example, if an investor paid $9.56 a share for a closed-end fund whose net asset value is $10 per share — typical of the 4.4% discount — then a 3% dividend, or 30 cents per share, would amount to a 3.14% return.
Since they don't have to keep cash on hand to redeem shares like mutual funds, closed-end funds have more funds to invest, though in down markets, lack of a cash reserve can hurt. Closed-end-fund portfolio managers also have more opportunity to leverage their funds by borrowing money to invest.
But that leverage makes for a risky and more volatile investment, warns Nuveen Investment's research website, cefconnect.com. The leverage creates a multiplier effect on changes in the fund's net asset value, which can backfire in a down market.
Returns also take a hit when short-term interest rates exceed long-term rates, which last happened in 2006. The funds typically borrow money at short-term rates to make long-term investments.
BIGGER DIVIDENDS
According to Mr. Scott's data, 96% of open-end mutual funds and 95% of ETFs paid less than 5% in annualized dividends over the past 10 years, while almost 90% of closed-end funds paid more than 5% and almost 30% paid more than 8%.
“Mutual funds failed us in 2008, and we are seeing it again now,” said Janet Barr, president of Collaborative Financial Solutions LLC, who often uses unit investment trusts, a type of closed-end fund for the $35 million she manages. “Clients want products outside of mutual funds.”
Ms. Barr cited an August report by ratings agency Standard and Poor's which found that only about one-third of actively managed large-cap and small-cap mutual funds outperformed their benchmarks over the past three years. Performance was even worse for actively managed midcap mutual funds. Only about one-fourth outperformed the S&P MidCap 400. The results have soured some clients on mutual funds.
In addition to the benefits of NAV discounts and the ability to invest the fund's assets fully, closed-end funds typically have lower marketing and distribution fees because funds don't market shares after the IPO, Ms. Barr said. “Bottom line, as time goes on, a lower fee structure can help benefit performance,” she said.
Share price variance from asset value over time is a handy metric for gauging value and is widely available on closed-end-fund research sites, said Mr. Fertig, who usually waits at least six months after a closed-end fund launch before he considers buying.
Although Mr. Fertig likes the arbitrage potential when closed-end-fund shares trade at a big discount to their net asset value, he sees some disadvantages compared with mutual funds. “With mutual funds, you don't have to think about discounts,” he said. “You buy at net asset value and sell at net asset value. It is one less thing to think about.”
Because closed-end-fund shares are traded on an exchange rather than being redeemed by the issuer, it can be more difficult to buy and sell, particularly for a less liquid fund. “If you want to buy 10 million shares, it will take some time and is more labor-intensive than buying a mutual fund,” Mr. Fertig said. “For many advisers, it is not worth it.”
DRAWBACKS OF MUTUALS
Jon L. Ten Haagen, founder and principal of Ten Haagen Financial Group, noted that since closed-end funds consist of a fixed portfolio, they don't incur the trading costs of mutual funds.
“Mutual funds can buy and sell multiple times a day,” said Mr. Ten Haagen, who manages about $30 million, noting that funds also are subject to style drift.
“You don't know what's in the portfolio” on a daily basis, he said.
Email Lavonne Kuykendall at [email protected]
