Closed-end funds (CEFs) are a relatively under-followed type of investment that often provide high income yields.
They represent a rather small and inefficient market, which allows patient investors to pick up deeply undervalued assets during periods of weakness.
However, because closed-end funds are generally actively-managed portfolios with high management fees, they tend to underperform the market as a group. More often than not, they enrich the fund managers more-so than the investors, but there are some exceptions.
There are a lot of misunderstood aspects about closed-end funds, and many readers have asked me to write about them. This article takes a look at some of the pitfalls and opportunities, and then showcases a few high-yield closed-end funds that consistently beat their benchmarks.
Closed-End Funds: Problems & Opportunities
Normal open-end mutual funds and exchange-traded funds (ETFs) generally trade at or near their net asset value (NAV) because they frequently issue and redeem shares.
In other words, the fund represents a pool of assets, and the sum of all of those assets divided by the number of shares will closely equal the price of a share of that fund. Like, if you analyze all of the holdings of an ETF and calculate what those assets are worth per share of the ETF, it’ll be very close to the ETF’s current share price. It’s efficient.
This is not the case for closed-end funds. The CEF’s share price can differ significantly than its per-share NAV. If you add up the value of all of the assets and liabilities of a CEF, and determine what it should be worth per share, the actual share price is often quite different (and usually lower).
The way that a CEF works is that when it is created, it does an initial public offering (IPO) and becomes publicly traded. From then on, the manager of the fund no longer buys or sells its shares as a matter of normal operation, although they may still do opportunistic buybacks in some cases. That’s why it’s called “closed”.
What this means is that the share price of a CEF is determined entirely by market forces, and markets can indeed be inefficient. The CEF market is rather small and popular among retail investors more-so than institutional investors, so it seems to represent a more inefficient market than average.
Therefore, shares of a CEF can often trade at deep discounts to their NAV, or at steep premiums.
Investors generally want to buy into a CEF that has been outperforming lately, and they may or may not even look at the NAV before buying into it. Therefore, they might drive the share price much higher than the fund’s NAV.
Likewise, if a CEF is under-performing lately (even if it’s well-managed and the sector the CEF focuses on happens to be in a downtrend), investors may want out, and are willing to sell the shares at a price far below the fund’s NAV.
Paying a high premium over NAV for a CEF is almost always a bad idea. Inversely, buying shares of a well-managed CEF when it is at an unusually large discount to NAV can be a strong investment. Patient, contrarian investors can often find great opportunities in the inefficient market of closed-end funds.
The other unique feature of CEFs is that because they don’t need to be ready to redeem shares, they can invest in more illiquid assets or use leverage to boost returns. Basically, they have more freedom than open-end mutual funds or exchange-traded funds. Very good managers can use this feature well, but it can also backfire and result in a poorly-managed fund blowing itself up.
The Active Management Drag
Over any given period, 80% or more of actively-managed funds underperform the S&P 500. This number increases to over 90% for 15-year periods.
Chart Source: SPIVA
It’s not because active managers are dumb; it’s because the benchmark represents a zero-sum game. Active managers as a group roughly equal the benchmark before fees, but when fees of 1% or so per year are included, active managers as a group underperform the benchmark net of fees.
And it’s not as easy as just buying funds of managers that have outperformed for a few years. When a manager is on a hot streak, money pours into the fund and their stocks tend to be more highly-valued due to recent success. If anything, it makes more sense to buy into managers that have a good process but that have underperformed recently.
Only a small percentage of fund managers consistently outperform throughout their career, and picking one ahead of time is about as hard as picking a stock that will dramatically outperform. Even better, but just as hard, is to identify firms that have a culture of outperformance, and that consistently build and operate funds that outperform their benchmarks even as star managers are replaced with the next generation.
The silver lining is that CEF investors can get around the active fee by buying when the CEF share price is at a deep discount to NAV. If a fund charges 1% per year in active management fees, and you buy it when it is trading at a 10% discount to NAV or more, you are effectively cancelling out a decade or more of fees. Therefore, closed-end funds are one the better ways to access active management if you don’t want a purely passive portfolio.
The Dividend is Not What it Seems
The reason that closed-end funds are popular among retail investors is that they usually have high dividend/distribution yields of 5%-10%.
However, it is important to realize that this is usually an illusion. It’s not that the fund is generating excess dividends; it’s that it is selling some of its assets and giving the money back to you on a regular basis. Especially for equity CEFs.
It’s not much different than owning the S&P 500 and withdrawing 6% per year to cover your expenses. Right now, the S&P 500 has a dividend yield of less than 2%. So if you want to withdraw 6% per year, you can collect the dividends and then also sell 4% of your principle, and thus withdraw your required 6%.
That’s what most CEFs do. They return a combination of dividends and principle, and investors often think it’s just dividends, just free yield with no downsides. But the dividend is not a free lunch; it’s often a return of capital.
So, when buying a CEF, it’s important to ask yourself, “Why not just buy the lower-yielding benchmark and sell some shares when needed?” More often than not, it’ll be a better-performing and less-expensive method. The CEF has to give you some kind of edge to make it worthwhile besides just the yield.
That’s not to say that focusing on dividend income is bad. The dividends of actual dividend stocks themselves are less volatile than their share prices. Here is a chart that shows the price and dividend performance of the S&P 500 for the decade surrounding the subprime mortgage crisis:
Data source: multpl.com
Dividends on this chart were a lot less volatile than share price, and that doesn’t even include any sort of filtering process to find the safest yields.
So, relying on dividend income to cover expenses rather than selling principle makes sense when possible. Focusing on stocks that pay dividends is a sensible strategy for a retirement portfolio, and I have an article on 20+ high-yield stocks I like.
However, many CEFs simply don’t operate like high-yield dividend stocks; they frequently return principle.
Returning capital isn’t necessarily a problem. It can be a psychologically useful strategy for investors to hold onto shares of CEFs as part of their portfolio, never sell them, and fund their expenses with their distributions. Many CEFs pay distributions monthly, which can also be useful for smoothing out your investment income. Additionally, well-run CEFs can optimize the tax situation, which can make them useful for taxable accounts.
But investors should be aware that this is not so fundamentally different than regularly selling shares of something like the S&P 500 or similar index fund.
CEF NAV Discount/Premium Examples
Before buying any closed-end fund, check its share price compared to its net asset value (NAV). Try to only buy when the fund is trading at a deeper discount to NAV than its historical average.
A great source for this is CEF Connect. You can look up the ticker of most CEFs and see their historical share prices, historical NAVs, and historical discounts/premiums between the share price and NAVs.
Example 1) Delaware Investments Dividend & Income Fund (DDF)
The DDF CEF has historically traded at a discount to its NAV, but over the past year it has switched over to trading at a big premium to NAV:
Source: CEF Connect
Investors are paying a lot more for the assets than the value of the assets themselves. That’s not a great position to be in and it is historically unusual for this fund.
Example 2) Aberdeen India Fund (IFN)
The Aberdeen India Fund has a long history of wild discount/premium swings:
Source: CEF Connect
In the late 1990’s and early 2000’s, nobody wanted to hold emerging markets and everyone wanted to hold U.S. tech stocks. As such, the India Fund was trading at a huge 35% discount to NAV.
In 2006, everyone was obsessed with the BRICs, the big emerging markets. The valuations of China, India, and Brazil all became dramatically overvalued. As such, the India Fund traded up to a 35% premium to NAV because investors couldn’t get enough of it. Investors who were smart enough to buy it when it was at an extreme discount, hold it while India’s stock market did fine, and then sell it when the CEF started trading at a premium to NAV, made very good returns. Such investors benefited both from the improving fundamentals and the positive 70% NAV discount/premium swing around those fundamentals.
Over the past five years, the India Fund has traded more rationally at a moderate discount to NAV. But even during this period, it has traded for as little as a 6% discount to NAV to a nearly 16% discount to NAV. Buying into the India Fund during dips has historically been quite lucrative.
5 Closed-End Funds Worth Buying On Sale
A lot of people google terms like, “best CEFs to buy in 2020” or “top high-yielding closed-end funds” and other phrases like that.
Kiplinger and other publications often cater to this demand by producing lists of “best closed end funds for <insert year here>”. Give their 2019 version a read here if you want; it can be a nice starting point to find ideas. Dividend Detective has a more quantitative ranking that simply shows which CEFs have been outperforming recently, which is also a nice sample to be familiar with.
However, it’s important to do your own homework rather than to just buy funds from a list, including my list. 🙂
One of Kiplinger’s recommendations, for example, was the Eaton Vance Enhanced Equity Income CEF (ticker: EOI) which has similar holdings to the S&P 500. Kiplinger cites the CEF’s ability to use leverage or options strategies to enhance dividends compared to a standard index.
Unfortunately, this fund has a long history of underperformance, so it’s hard to see why it’s worth owning this fund compared to owning the S&P 500 and selling some shares as needed for expenses:
Similarly, Kiplinger recommended the Tekla Healthcare Investors CEF (ticker: HQH). The article talks about how this CEF has outperformed the passive SDPR S&P Healthcare Sector ETF (ticker: XLV) for a long time thanks to focusing on biotech stocks.
At first glance, I can see what the author was thinking here, but on a deeper analysis, not so much.
The first problem is that virtually all of the outperformance was in the first year in the late 1990’s; during the two decades since then it hasn’t really outperformed. The second problem is that the fund underperformed the passive iShares Biotech ETF (ticker: IBB) and the passive SPDR S&P Biotech ETF (ticker: XBI) over a long period of time:
So, what value does this CEF add for investors compared to passively investing in the biotech sector? The CEF’s fee is more than twice that of the iShares Biotech ETF and about three times as high as the SPDR S&P Biotech ETF, but depending on which long time period you look at, it’s hard to say that it’s really providing outperformance.
Buying into the S&P 500 is virtually free, and provides diversification into 500 large American companies with global exposure. Similarly, building a portfolio of low-cost ETFs to have even more diversified global equity and bond exposure is also nearly free.
So, when picking a CEF, a useful exercise is to ask yourself which of the following criteria it satisfies:
- Does this fund have a high probability of outperforming the S&P 500 on a risk-adjusted basis?
- Is this fund sufficiently non-correlated to the S&P 500, and therefore useful as an accompaniment to the S&P 500 in a portfolio?
- Is it a temporary opportunity, trading at an unusually large discount to NAV?
- Does the fund have some psychological or time-saving benefit that makes it preferable to owning an index?
If a fund doesn’t meet one or more of those criteria, I’d think hard if it’s worth owning at all.
Without further ado, here are 5 closed-end funds that I think are worth buying when they are trading at a bigger-than-normal discount to NAV.
BlackRock Enhanced Capital and Income Fund (CII)
BlackRock has several non-leveraged equity CEFs that sell covered calls over a portion of their holdings to generate income.
Their Enhanced Capital and Income Fund (ticker: CII) has roughly matched the S&P 500 in terms of total returns since its inception in 2004:
Holding this fund offers two potential benefits over the S&P 500.
The first benefit is that it pays monthly dividends and a high yield. Investors don’t have to manually sell their own shares over time. They can just hold onto the shares and spend their distributions, which might make it easier to conserve principle during retirement.
The second benefit is that like many CEFs, its discount to NAV fluctuates over time. During periods of market distress, this fund tends to trade at a bigger-than-normal discount. Opportunistic investors who buy in during those times may make a return that exceeds the S&P 500.
Aberdeen India Fund (IFN)
Aberdeen’s India Fund has outperformed the MSCI India benchmark since its inception in 1994, and has outperformed the passive equivalent, the iShares MSCI India ETF (ticker: INDA) since the ETF’s inception in 2012 as well:
This performance has been very consistent. In addition to outperforming the benchmark since inception, it has also outperformed over the past 10 years, 5 years, and 3 years.
India is sufficiently different than the U.S. stock market, and this CEF can certainly warrant a place in a diversified portfolio.
DWS New Germany Fund (GF)
Similarly, The New Germany Fund of DWS has outperformed the iShares MSCI Germany ETF (ticker: EWG) over two decades:
The caveat is that all of the outperformance is from 2010 to the current time; the most recent decade. Could this be a case where buying into a fund that has recently outperformed ends up backfiring?
Still, a decade of outperformance, especially of this magnitude, is an uncommon feat. It’s not like buying into a fund that just did well over the past few years. For investors that are bullish on Germany, it may be worth giving this fund a chance as long as current management stays on board. It can also be a good accompaniment to U.S. stocks as part of a diversified portfolio.
In addition, this fund has occasionally traded at discounts to NAV of 20-25% or more, giving opportunist investors a good bargain during major bear markets.
Templeton Emerging Markets Fund (EMF)
This emerging market closed-end fund has roughly matched the performance of the iShares Emerging Markets ETF (ticker: EEM) over the long term:
If you want to collect yield from emerging markets without worrying about selling shares, owning this fund makes sense.
In addition, the fact that it occasionally swings from a -20% discount to NAV to a +20% premium over NAV gives opportunistic investors attractive entry points from time to time. Investors paying attention to the premium/discount spread can benefit from this extra volatility rather than suffer from it.
PIMCO Corporate and Income Opportunity Fund (PTY)
It’s a rare thing for a bond fund to outperform the S&P 500 over a long period of time, but PIMCO’s Corporate and Income Opportunity Fund has pulled it off:
Unlike the others on this list, this CEF is not one I would buy now. It is trading at more than a 20% premium to NAV. However, it’s worth putting on your watch list.
This fund has a diverse collection of bonds, and the focus is on high-yield corporate credit and mortgage debt. In addition, it is leveraged. That makes it quite risky, especially this far into the market cycle after such a long streak of outperformance.
This fund has a history of severe drawdowns during economic slowdowns and bear markets, which may present a buying opportunity next time we have an environment like that.
There are hundreds of CEFs, including some good ones I haven’t covered here. In particular, I haven’t analyzed fixed-income CEFs as much as equity CEFs, because fixed income isn’t my forte.
The key takeaway is to ask yourself a few questions before buying a CEF:
- Would I be better off owning this active fund, or its passive benchmark? Has it consistently outperformed or no?
- Where does the dividend come from? Am I chasing yield or does the total return of this fund make sense?
- How does its current price compare to its NAV? When looking at CEF Connect, how does the fund’s current discount/premium to NAV compare to their historical premium/discount?
- How much leverage, if any, does the fund use?
There are some exceptional managers and disciplined firms that can reliably produce outperformance. Most managers and firms cannot, and there is no free lunch. The high distribution yield of CEFs is generally not as sustainable as it seems, and the active fees associated with CEFs are rarely justified by consistently better returns than a benchmark.
Do your homework before buying a CEF. The best combination is to find one that a) has a long track-record of outperformance but that b) is currently at a larger-than-normal discount to NAV due to bearishness about the sector itself. In other words, stick to the best funds and buy them when they are on sale.