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Robert Powell: Hi, I'm Robert Powell, editor of Retirement Daily here at TheStreet, and today I'm talking with Jeffrey Levine who is the CEO and Founder of Blueprint Wealth Alliance and also the Director of Advisor Education at Kitces.com.

Jeffrey, welcome.

Jeffrey Levine: Thank you so much for having me.

Robert Powell: So, today, one of the things I'd like to talk about is closed-end funds. We now have on our website a section dedicated to closed-end funds for the benefit of advisors as well as investors, but one of the main questions I've always had about closed-end funds is this notion of how do I actually, if I'm an advisor, incorporate this structure into a client portfolio? How do I think about it relative to all the other things I might own and measure it relative to all the other things I might own?

Jeffrey Levine: So, I think that's the biggest thing, right, is that there's always options out there, and we've got to see what are the unique advantages and the unique disadvantages that come along with closed-end funds, and like everything else, there's no free lunches, but there are some unique advantages that we can get, particularly as professional advisors.

For instance, if we compare closed-end funds to let's say open mutual funds. With the open mutual fund, you generally are having net asset value at the end of the day, so there's not really the same trading of at a discount or at a premium as you can see with a closed-end fund. With a closed-end fund, you often see that a lot more, so you might find investments that within the closed-end fund, for instance, are valued at $10, but the closed-end fund itself is trading on the exchange at $9.

So, there is an inherent value there that may be available. And again, for professional advisors that are better able to analyze that and have those tools or at least very educated investors, then you're typically in a better position to take advantage of those. Now, obviously it comes with risks as well because you could be buying things at a premium, whereas and again, with an open-end mutual fund, you don't see that. So, that's probably the biggest difference between a closed-end fund and a mutual fund that's going to impact most investors.

The other thing is that once the closed-end fund is finished taking up money, it's done. Right? There's no more raising of fund as the managers and have to worry about redemptions from time to time, so they are definitely operational advantages of the closed-end fund for the manager. They don't have to worry about deploying a significant amount of cash or whatnot. They just run the pool of money that they're running, and obviously, again, when you don't have to worry about keeping aside a sleeve of cash, you can potentially eliminate drag that a typical mutual fund might have because they've got to set aside enough money that if someone decides they want to sell out at the end of the day, they can pay those bills.

Robert Powell: Right. And so when you think about all the, if someone wanted, broadly speaking, income for instance, and they have any number of structures to look at. We identified open and closed-end, but there's unit investment trust, there might be BDCs, it might be MLPs, it might be REITs, and so in the vast universe [crosstalk 00:02:41].

Jeffrey Levine: Absolutely yeah. You can go on forever.

Robert Powell: Right. And so all of them, if I'm thinking about what's the best opportunity for my client or for my portfolio, I have all this plethora of options, and why closed-end funds versus say UITs, MLPs, BDCs, et cetera?

Jeffrey Levine: Well, particularly with fixed income funds, if you can buy them on the discount, stocks tend to trade at least a little bit closer typically to their net asset value, so there's a little bit more of a swing there, and again, for the educated investor, for the advisor, there may be a better advantage to take care of that discount, the ability to buy there. The other reason is that it makes an attractive, oftentimes simple way of creating an income stream on a monthly basis for investors.

So, those are really the big things that an advisor might look at. The one thing that you have to be careful of on the flip side would potentially be the closed-end fund may have greater liquidity concerns if you actually want to exit that fund. Right? So there's a difference between just taking money in the ordinary dividends that you're getting on a regular basis versus I'd like to sell this fund. In a panic market for instance, or if everybody wants to get out, you've got to sell that on an exchange, and you're only getting what someone else is willing to pay. So, that same advantage of buying at a discount, again, can work in your advantage when buying it, but if you have a liquidity crisis can also work against you.

Now, again, for the educated investor, for the smart advisor, they're hopefully going to know enough to not sell during those times, but that's one of the main reasons that for your average investor who's just looking to buy and hold, closed-end funds may not be as advantageous to them.

Robert Powell: Yeah. So, let me go back to my first question, too, about incorporating into a portfolio. With traditional investment stocks and fixed income securities, I might look at using modern portfolio theory and look at risk adjusted return and think about Sharpe ratios and Treynor and-

Jeffrey Levine: All those fun things, yeah.

Robert Powell: ... all those fun things, and so do I have to think differently about these when I think about adding?

Jeffrey Levine: Well, you want to look at the components of the portfolio, right? You want to understand what the manager is holding within their, what type of closed-end fund it is because we could have a closed-end fund that is a very specialized in one area versus the other, and you just want to incorporate that as part of your overall portfolio mix. Right?

So, if you have, let's say you own 10 individual bonds with part of your portfolio. You may not want to use the other part of your portfolio to buy the closed-end funds that also own bonds. You may want to use that to buy stock or closed-end funds that buy stock, et cetera.

So, we really want to ... Closed-end fund by itself is not necessarily the diversification factor. It's what's inside that closed-end fund, but just like open-end funds, closed-end funds do have the added advantage of spreading your risk over a lot of different assets, and particularly for fixed income investors, that can be very important because a lot of times if you want to go and buy a bond, let's say on an open market. First off, you got to buy in reasonable quantities. 10 pieces at the minimum usually, maybe 25 pieces. So, that means you're committing $10,000 to $25,000 at a minimum to buy an individual position.

Robert Powell: Somewhat risky.

Jeffrey Levine: Yeah. What if you don't have that much? What if you only have, let's say, and I say only, but what if it's only $100,000? You're only going to be able to spread out between four to 10 positions at most. That's probably too much of a concentration in your portfolio.

So, closed-end funds do offer the advantage of being able to take that $100,000 now and being able to spread it over tens, maybe even hundreds of different fixed income investments within that portfolio.

Robert Powell: Right, and if you're talking fixed income in particular, a closed-end fund, I think, offers you a duration that may be different, say even though the structures or the investment objective is similar to an open-end fund, the duration on an open-end fund might-

Jeffrey Levine: [inaudible 00:06:32] might go on forever.

Robert Powell: Right. So, you have no control over that percentage [crosstalk 00:06:35].

Jeffrey Levine: That's right. At some point with the closed-end fund, you should theoretically see an end to those. You have a better idea of what the cycle is on the maturity, for sure.

Robert Powell: Right. So, from your perspective, if you're speaking to an advisor about whether they should incorporate these for the benefit of their clients, any thoughts about like what are the top two, three things that they absolutely must think about, know?

Jeffrey Levine: So, I think the first one definitely is one we've hit on already, right? It's understanding the relationship of premium to discount on the purchase and the sale, but one of the other things is where are you holding this asset? From a tax perspective, are you holding this inside your regular money, your after tax account? Are you holding this inside your tax deferred account, like an IRA? Are you holding this in a Roth IRA.

Now, typically if we're talking about fixed income closed-end funds, generally we're not expecting to see the dramatic appreciation that we would with stocks or other more risky but higher return or higher expected return investments, so typically the Roth IRA is not your best sleeve to hold that in. From a taxable versus a tax deferred account though, many people for years have been taught what you should do is you should put your interest bearing investments in your tax deferred account, and the reality is, at least today where interest rates are, the math doesn't really bear that out. Many instances it's actually better still to hold those income bearing investments in your taxable account and own your stocks in your tax deferred account.

Now, you're taking qualified dividends-

Robert Powell: So, that's contrary to-

Jeffrey Levine: ... you're taking capital gains, yeah, and you're turning that tax favored income into not tax favored income, right? Into ordinary income. But here's the thing today, what's your deferral really worth on the interest? Right? You're not deferring that much because interest rates are still very low, and at the same time, if you're getting this capital gain on stock, even assuming a reasonable turnover rate of even a low turnover rate of 20% a year, 25% a year, the math bears out that you're actually better off reversing the traditional way of holding things and holding those potentially those fixed income closed-end funds in your taxable account and having more of your growth end stock inside your IRA.

Robert Powell: There you are challenging conventional wisdom yet again.

Jeffrey Levine: That's right. If not for that, what else do I have to do? I'd have nothing else to wake up for in the morning.

Robert Powell: All right, so obviously we'll need to see the math on this and all that, but it's a compelling argument that you make to do that. So, okay, so account location is important.

Jeffrey Levine: Absolutely.

Robert Powell: Dividend, premium discount. Closed-end funds also, unlike open-end funds, can use leverage, and that for some people might be a bit a new, right?

Jeffrey Levine: For sure. Yeah, yeah. It adds another level of risk to the portfolio, right? Anytime you're talking about leverage, it gives you more opportunity for award; it gives you more opportunity for risk just the same way. I mean, just a simple example for people to understand why that is. If you buy something, let's say all in cash, and it goes up 10%, you bought it for $100,000 dollars, you've made $10,000, you've made 10%.

Now, if it were to go down $10,000, you've lost 10%, but if you were to buy that same portfolio and you were to, let's say you financed the whole thing, right? Well, you just made $10,000, an infinite essentially return on investments because you didn't put up any money to begin with, and on the same side though, if you now borrow $100,000 and you lose $10,000, it's a much bigger ask to pay that back over time.

So, again, you're relying on the managers intuition and insight, and that's why even doing due diligence on the manager of a closed-end fund oftentimes can be just a little bit more important than an open-end fund because of all these other aspects that the closed-end manager may have at their disposal and tools that they may have. You want to make sure that you're working with a team that obviously knows what they're doing and has a proven track record of using debt and all the available tools in a responsible manner.

Robert Powell: Yeah. It seems like, not to say that people shouldn't use closed-end funds, but maybe to reiterate that they have to be that much more diligent given that you'd need to know about the discount, the premium, the leverage, and whatever other underlying securities in the fund.

Jeffrey Levine: There are very few things I think makes sense for all investors or make sense for no investors. Right? So, just like some people should have a percentage of their portfolio that's 90% stocks and 10% bonds and others are kind of flip flopped, and of course you have all the other interesting things in there like alternative investments and cash and whatnot, but same thing here, right? You have a scenario where closed-end funds probably are not right for everybody, but there's definitely a section of the population that could benefit from owning them in some way, shape, or form.

Robert Powell: Yeah, and I liken it to this: I think no one would ever go to a doctor who couldn't prescribe all the medicine in the PDR book, so this is just one more [crosstalk 00:11:25] tool that you should know about and use.

Jeffrey Levine: Absolutely.

Robert Powell: All right. Anything else to add that we haven't touched on?

Jeffrey Levine: No, I think that pretty well covers it.

Robert Powell: All right. So, I'm Bob Powell, Editor of Retirement Daily. On behalf of my colleagues here at TheStreet, I'd like to thank Jeffrey Levine for coming on to talk about closed-end funds. Thanks for joining us.

 

 

What Are Closed-End Funds?

Closed-end funds are baskets of stocks that are grouped according to an investment objective and overseen by a manager.

Unlike open-end funds, which continue to increase their asset base by selling to new shareholders, closed-end funds bring in assets by selling a fixed number of shares through an initial offering. After the initial sale, the closed-end fund's shares trade like stocks on exchanges like the NYSE or the AMEX.

Low demand for a fund can cause closed-end shares to trade at discounts to net asset value. High demand can create premiums to NAV.

Retirement Daily's Robert Powell recently sat down with Jeffrey Levine, CEO and Founder of Blueprint Wealth Alliance and also the Director of Advisor Education at Kitces.com. 

Robert Powell: "One of the main questions I've always had about closed-end funds is this notion of how do I actually, if I'm an advisor, incorporate this structure into a client portfolio? How do I think about it relative to all the other things I might own and measure it relative to all the other things I might own?"

Jeffrey Levine: "So, I think that's the biggest thing, right, is that there's always options out there, and we've got to see what are the unique advantages and the unique disadvantages that come along with closed-end funds, and like everything else, there's no free lunches, but there are some unique advantages that we can get, particularly as professional advisors.

For instance, if we compare closed-end funds to let's say open mutual funds. With the open mutual fund, you generally are having net asset value at the end of the day, so there's not really the same trading of at a discount or at a premium as you can see with a closed-end fund. With a closed-end fund, you often see that a lot more, so you might find investments that within the closed-end fund, for instance, are valued at $10, but the closed-end fund itself is trading on the exchange at $9.

So, there is an inherent value there that may be available. And again, for professional advisors that are better able to analyze that and have those tools or at least very educated investors, then you're typically in a better position to take advantage of those. Now, obviously it comes with risks as well because you could be buying things at a premium, whereas and again, with an open-end mutual fund, you don't see that. So, that's probably the biggest difference between a closed-end fund and a mutual fund that's going to impact most investors.

Want to Buy $1 Worth of Stock for 90 Cents or Less?  Click here to register for a free online video in which TheStreet's retirement expert Robert Powell and an all-star panel. The webinar is sponsored by Nuveen.