By Will Rhind
In the previous three articles of this four-part series on pass-through securities, we’ve offered insight into master-limited partnerships (MLPs), real estate investment trusts (REITs) and business development companies (BDCs). The series now concludes with a focus on closed-end funds (CEFs).
CEFs are ‘40 Act funds that go to market via an initial public offering (IPO) process and are listed on a stock exchange. Their structure is similar to exchange-traded funds (ETFs) or mutual funds, but with one significant difference — CEFs have a fixed amount of share capital, as opposed to the issuer being able to offer an unlimited number of shares over time, hence the name “closed-end.”
Once the number of shares is set for a CEF, that’s it. If you raise $100 million for the fund through an IPO, that is the total amount of capital in the fund available for the manager to invest. Investors then trade the fund shares on the stock market and the share price reflects both the value of the fund and supply and demand for the shares at that time.
The only way the issuer can increase the size of the fund is to undertake a secondary share offering. The two most common ways to do this are a rights issue where the secondary share offering is only available to existing shareholders, or a “shelf offering” where you do not have to be an existing shareholder to participate. In this regard, the CEF listing process and secondary share trading activity is very similar to the stock market listing and trading of shares in a traditional corporation.
In the current environment, one of the most appealing aspects of CEFs, specifically, and pass-through securities generally, is the vital role they can play in helping investors find yield. That search for yield has proven very difficult dating back to the financial crisis of 2007-08, which resulted in interest rates being dropped to almost zero.
It took about seven years for the Federal Reserve to begin raising rates again, and even then, only modest levels were reached before the pandemic struck last year and caused another decrease to zero. Accordingly, a deep income crisis has afflicted the American economy for more than a decade.
Pass-through securities can help address this pressing issue because they are exempt from corporate taxes, and therefore, required to distribute essentially all of their earnings to shareholders.
The first CEFs were introduced in the U.S. in 1893 — more than 30 years before the first open-end funds. Today, there are 479 CEFs, with a total market capitalization of nearly $500 billion and an average current dividend yield of 3.2%. Thus, CEFs represent the largest category of the four pass-through securities profiled in this series, ahead of the 166 REITs, 71 MLPs and 47 BDCs.
In terms of income, a CEF is a collective investment scheme or a fund, so CEFs that invest in income-generating assets have multiple potential strategies. For instance, a CEF might invest in different types of bonds, such as high-yield or “junk” bonds, or in less liquid income-generating assets like bank loans.
CEFs can also borrow money, which is known as leverage. One reason for doing this is the potential to increase expected returns by leveraging assets and borrowing at lower interest rates. In this way, CEFs are distinguished from other investment options such as ETFs and mutual funds that typically do not use leverage.
CEFs tend to be actively managed, which means a portfolio manager is employed to invest investors’ capital in order to execute the fund’s investment strategy. This is in contrast to most ETFs, for example, that track an index and are not actively managed.
Another important differentiator is that CEF shares frequently trade at a discount to the net asset value (NAV) of the fund. This is because their trading activity isn’t linked directly to the NAV of the fund and instead factors in supply and demand for the shares on the market at any given time. There is no arbitrage mechanism available as with an ETF allowing shares to be created or redeemed at NAV. The potential discount offers another avenue for investors to increase income, based on the premise that if you purchase an asset at a discounted rate and it converges to NAV, you’ll benefit from that appreciation.
The fact that CEF shares can trade at a premium or discount to NAV also represents a possible risk factor though, as there is no guarantee that any given fund’s shares are trading at a discount to NAV or that the share will converge to NAV over time. Another risk can be potential lack of liquidity if the shares of a fund aren’t particularly popular.
All about Income
The attraction of CEFs for retirees and pre-retirees is all about income and the quest to find it in an investing environment that’s often barren of yield. Because the tax treatment for income-generating CEFs is pass-through, ownership of them is just like owning other pass-through securities like BDCs, MLPs, or REITs.
CEFs are obligated from a tax and regulatory perspective to distribute substantially all of their income to shareholders, so if the fund generates $100 of income, you as the investor would receive $100 less any associated management fees or fund expenses. Because of the underlying assets that CEFs can invest in and the leverage they can deploy, these funds are capable of producing a high level of income. Considering that the 10-year Treasury note is currently yielding only 1.6%, that type of income potential is difficult to ignore.
For anyone who is interested in learning more about CEF performance, the S-Network Composite Closed-End Fund Index (CEFX) is a rules-based index intended to provide investors with a means of tracking the overall performance of a global universe of U.S.-listed CEFs. It is reconstructed on a quarterly basis from a selection of approximately 350 CEFs.
There are ETFs that invest exclusively in BDCs, MLPs, REITs, or CEFs. However, I believe an alternative and potentially more attractive option for retirees and pre-retirees would be to invest in an ETF that diversifies its holdings across all the different sectors of the pass-through security universe. This approach offers investors a great opportunity to benefit from the high income potential of pass-through securities while avoiding excess risk exposure that could be associated with any one type.
About the Author: Will Rhind
Will Rhind is the founder and CEO of GraniteShares, a New York-based independent exchange-traded fund (ETF) issuer that seeks to launch innovative and disruptive ETF investments. Will is an established ETF entrepreneur with more than 20 years of experience in the industry. Prior to founding GraniteShares, Will served as the CEO of the World Gold Trust Services, overseeing the world’s largest commodities fund. He was also a senior executive at ETF Securities from 2007 to 2013 as well as a former principal at iShares. Will is a graduate of the University of Bath in England.
Past performance is not a guarantee of future results. One cannot invest directly in an index. For full disclosure, GraniteShares manages the GraniteShares HIPS U.S. High Income ETF (HIPS), which invests in a basket of pass-through securities.
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