Hot Yields Drive Rebirth of Closed-End Funds

Yield is driving investors to these out-of-favor instruments.
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For years, closed-end funds have been overshadowed by their more glamorous cousins, exchange-traded funds. Now they're staging a comeback.

Key to their success is a renewed interest in investments that generate yield as baby boomers approach retirement age. But closed-end fund managers have also had to adapt and overhaul their investment strategies as some of the traditional sources of yield disappeared.

Since November, the record for largest initial public offering for a closed-end fund has been broken three times.

Like ETFs, closed-end funds are traded on an exchange. But unlike ETFs, which are created and dissolved as needed, closed-end funds issue a fixed number of shares. This structure lends itself to investing in illiquid securities and using leverage to juice returns, because managers don't have to worry about raising cash to meet redemptions.

It also has a major drawback: share prices of closed-end funds can move sharply out of line with the value of their holdings, allowing investors to snap them up at a discount or forcing them to pay a premium.

By comparison, investors love ETFs for their low fees and tax advantages. ETFs also tend to closely track the net asset value of their component securities. That's because market makers create new shares when prices move up to a premium over NAV and dissolve them into their constituent securities when prices fall to a discount.

In recent years ETFs surpassed closed-end funds in total assets, with about $420 billion in ETFs at the end of 2006, compared with $300 billion or so in closed-end funds. Both, however, are dwarfed by open-end mutual funds, which have more than $10 trillion in assets.

Wall Street has reacted to the shift, with many investment banks getting rid of their closed-end fund analysts. Even Morningstar stopped providing editorial analysis of closed-end funds toward the end of the 1990s, although it has since resumed.

Now, not only is the closed-end fund industry not declining, for the first five months this year, it saw more new launches than each of the last three years. This year through May 31, 22 closed-end funds hit the market, bringing in total net proceeds of $19.74 billion, or an average of $897.1 million per fund, says fund research firm Lipper. Compare that with 2006, which saw 21 offerings the whole year, and total net proceeds of $10.1 billion, averaging $481.3 million each.

"Some people did think ETFs were going to bury closed-end funds, much like people thought index funds would be the end of actively managed funds in the 1990s," says Jonathan Isaac, vice president for closed-end products at Eaton Vance. "But I think people are moving to closed-end funds because they offer an extremely attractive alternative to other fixed-income vehicles. Nothing can compare with the yield offered in a closed-end fund."

Yield is the percentage of total assets that investors receive as income or dividends. A 9% yield on a $100 investment would pay out $9 a year.

Isaac knows of what he speaks. The February launch of the

(EXG) - Get Report

Eaton Vance Global Tax Managed Diversified Equity Income Fund (EXG) not only broke the record for the largest IPO for a closed-end fund, but the $5.5 billion it raised made it the third largest IPO in the history of the

New York Stock Exchange

. As of May 31, it posted a yield of 9.53%, says Lipper.

Like many of the funds launched this year, the new fund invests in domestic and foreign stocks that pay big dividends. It also tries to take advantage of more favorable tax treatment of dividends paid on stocks held for more than a year.

That's a big change from a few years ago, when most closed-end funds invested in bonds. The low-interest rate environment has made bond yields much less attractive. In particular, the narrow difference between short-term and long-term interest rates has made it harder for closed-end funds to boost returns by borrowing money at short-term rates and investing it in longer-dated securities.

So managers have come up with other strategies for generating additional yield, such as issuing covered calls, index call options and preferred securities.

Jeff Margolin, closed-end fund and ETF analyst at First Trust Portfolios, says these strategies allow closed-end funds to offer higher yields than the 5%-range currently offered by certain bonds.

One of the biggest drawbacks of closed-end funds, their tendency to trade at a discount to NAV, is also improving. On May 31, the median discount for all closed-end funds was 1.81% -- a dramatic drop from a discount of 6.24% a year ago, according to Lipper.

Margolin says 38% of all closed-end funds are now trading at a premium to NAV, compared with a historical trend of between 10% to 15%.

"I think people are hungry for yield," says Anne Kritzmire, managing director of closed-end funds at Nuveen Investment, the largest provider of closed-end funds, with 118 funds and $53 billion in assets under management. She attributes a lot of the recent success to the ability of funds to "use leverage to pack in some gains."