We may finally be out of the deepest valley of interest rates, but it could be years before rates rise to more "normal" levels. In the meantime, many investment vehicles will struggle to reach the regular income that retirees and near-retirees require. At the same time, longer lifespans and rising medical costs only make the need for a reliable source of retirement income all the more urgent.
Closed-end funds are an idea worth considering, and advisers who use them typically allocate around 15% of a client's income portfolio to CEFs. These funds boast a number of unique structural characteristics - including more efficient portfolio management, easier access to less-liquid securities and professionally managed distributions.
Closed-end funds have been delivering income for decades. Designed for smooth, regular and often tax-advantaged distributions, they are one of the most efficient vehicles for building, growing and sustaining retirement income (although, of course, such income cannot be guaranteed). CEFs can offer the benefits of diversification by providing broad exposure to an array of potentially income-enhancing asset classes that may be difficult to access using other vehicles. They are positioned to generate income differently than their open-end mutual fund cousins and exchange-traded funds, ETFs, thanks to five key structural differences:
- Efficient Portfolio Management
Unlike mutual fund managers who must juggle constant inflows and outflows of cash, closed-end fund portfolio managers can put capital to work in a long-term strategy, without worrying whether their fund will have enough liquidity to pay back investors who sell (redeem) shares. Even though fund shares trade actively, the fund manager can remain focused on the fund's investment strategy because no cash is flowing into or out of the portfolio.
- The Potential to Buy at a Discount
CEF shares trade on exchanges, and their prices are determined by market demand and supply. As a result, CEF shares commonly trade at prices that differ from their net asset values. While CEFs are designed for long-term investors, not frequent traders, investors can still take advantage of a closed-end fund's periodic discount as an additional opportunity to potentially bolster income portfolio returns.
- The Ability to Invest in Less-Liquid Securities
Open-end mutual funds' liquidity needs can make it difficult or impossible for them to invest in less liquid or smaller-capitalization securities and markets, and private placements. Closed-end funds find it far easier to invest in specialized areas like these, thanks to their relatively stable asset bases. Regardless of the trading volume or market price fluctuations in these areas, closed-end fund managers are never forced to sell securities in a declining market to meet redemptions. Conversely, in a bull market, closed-end fund managers aren't inundated with new cash they must invest somewhere at rising prices. Stable asset bases also make it easier to take advantage of approaches such as leverage, long/short strategies, option overlays and managed futures, which have the potential to enhance the funds' diversification, return and cash flow.
- Leverage to Magnify Returns
Closed-end funds may borrow money or issue senior securities (preferred stock or debentures) to increase, or "leverage," their investment exposure. This, in turn, offers the opportunity to enhance portfolio income and performance. If the underlying portfolio return is positive, a leveraged fund typically will deliver higher shareholder returns and income than an unleveraged fund with the same strategy, simply because more assets are at work for the investor. Conversely, if the underlying portfolio return is negative, a leveraged version will suffer greater losses than an unleveraged version. That's why the use of leverage increases the likelihood of share price volatility and market risk. Time, however, can be a friend of the income investor. Over longer periods, leverage has historically delivered incremental income that has more than compensated for its associated cost and added volatility.
- Managed Distribution Policies
Many retirees struggle to budget for investment income that arrives as a quarterly or annual lump sum and may fluctuate. The unique structure of CEFs can provide smoother distributions from a wide range of asset strategies through a managed distribution program. A managed distribution program allows a fund to pay actual and expected capital gains throughout the year - not just in a single year-end distribution. This approach can be particularly helpful to increase diversification and income potential from investments in equities and other strategies with historically high appreciation potential rather than interest income. A managed distribution program essentially represents a CEF's commitment to provide shareholders with a predictable, but not assured, level of cash flow.
When comparing closed-end funds to traditional mutual funds, keep in mind that distribution rates and yields are different measures. A mutual fund's yield shows its interest and dividend income expressed as a percentage of the fund's current share price. The distribution rate of a closed-end fund might also include a return of capital, which can represent the fund's original capital or additional capital due to unrealized gains in the fund's portfolio.
A Different Vehicle for a Different Investment Landscape
At a time when traditional savings and income vehicles are still chugging along in low gear, vehicles like CEFs - built with the specific goal of producing high, consistent income - may be worth a closer look, especially for investors seeking to enhance their retirement income.