With Income at a Premium, Get Conversant in Closed-End Funds

Advisors know this story well: Treasury yields are low. So are yields on an array of other fixed income instruments and broader equity benchmarks sport paltry dividend yields.

That's a reminder, as repetitive as it may be, that unique approaches to income are as important today as they've ever been. Maybe “important” can be replaced with “necessary,” but the fact remains the same old income ideas aren't going to cut it today. Enter closed-end funds.

Closed-end funds aren't a new asset class, but these funds usually offer notably higher yields than high-yield bonds and real estate investment trusts (REITs), among other beloved income-focused assets. Additionally, there are income and tax benefits and methodology intricacies that make closed-end funds ideal conversation starters for advisors looking to bolster client engagement.

“To begin with, closed-end funds are exempt from corporate taxes on the condition that they pass through net investment income (interest and dividends) to shareholders,” according to Alerian research. “Most CEFs pay these distributions monthly—although some also pay quarterly—compared to traditional fixed income instruments, which pay coupons semiannually. CEFs also pay net realized capital gain distributions typically at the end of the year.”

Closed-End Points of Emphasis

The, S-Network Composite Closed-End Fund Index, a widely followed benchmark of closed-end funds, yields an astounding 6.44%. Using this index as a template, it's not hard to see why closed-end funds lob off so much income and why the asset class could be relevant to a broad swath of clients.

“The Index currently includes closed-end funds that invest in taxable investment grade fixed-income securities, taxable high yield fixed-income securities and others that utilize an equity option writing (selling) strategy,” according to Invesco.

Other positive traits pertaining to closed-end funds that advisors should highlight in client conversations include distribution policies and cash flow.

“Some equity and alternative strategy funds, however, expect to earn a large portion of their return through capital gains, rather than dividends or interest,” notes Alerian. “In this case, they can use a managed distribution policy, which attempts to forecast capital appreciation for the year and incorporate that into the regular monthly/quarterly distribution payment. This can benefit investors by providing more stable cash flows, but it also comes with the risk that the fund may overestimate the unrealized capital gain and return principal instead.”

Another point worth noting regarding the yield advantage of closed-end funds relative to open-end mutual funds and exchange traded funds is that the latter two fund structures issue new shares to accommodate incoming investors whereas the only shares issued by a closed-end fund are those sold during the initial public offering.

Owing to that fixed asset base, CEFs can make more efficient use of options leverage – a critical driver of higher yield and big point of differentiation relative to other fund structures.

Not Perfect, But Still Pretty Good

As is the case with any high-yield asset class, CEFs aren't perfect and come with trade-offs, but those areas are opportunities for both advisors and clients.

“For a typical investor, certain concepts like managed distribution policies and leverage for equity and fixed income funds, respectively, hold risks that may require some additional consideration,” concludes Alerian. “Even with firm knowledge of CEFs, it is still difficult to predict when a distribution cut will occur and how to take advantage of premiums/discounts. Risk averse investors may prefer to invest in CEFs through professionally managed index-linked products which provide access to a variety of CEF managers and styles, while still providing above average yield relative to most other sectors.”

Bottom line: CEFs don't need to command a significant portion of a client's portfolio, but the asset class is increasingly relevant in today's barren yield environment.

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