The Future of Closed-End Funds: Yield May No Longer be The Marketing Plan
Closed-end funds (CEFs) are three things: Permanent Capital, Active Management and Investor Liquidity. The fixed capital feature is where the “closed” comes from as funds are created through an IPO and do not offer a daily exchange of shares at net asset value (NAV). CEFs have active management and offer investors daily liquidity on US exchanges. We see these characteristics as benefits because the fund manager doesn’t have to deal with redemption and in-flow pressures. CEFs are also able to offer preferred stock and employ other forms of leverage. These unique features have allowed CEFs, especially in the past 10 years, to focus on yield-oriented strategies without having to face the same pressures that open-end funds have. With past trend of falling interest rates, it has been a very favorable environment for CEFs.
According to our CEF Universe data, from December 31, 2003 through December 31, 2013, there have been 218 funds IPOed from 59 different fund sponsors, raising approximately $125 billion in investible assets at IPO. For perspective the CEF Universe is now about $250 billion in total net assets. The average IPOed fund had approximately $570M in assets. Presently, 159 or about 73% of the funds have some amount of leverage employed with 145 (67%) using more than 10% effective leverage. It is fair to say CEFs generally use their leverage capabilities.
Leverage has been broadly applied in almost every corner of the CEF universe except Covered Call Equity Funds, which by design have the goal of a less volatile NAV, for which leverage would be unlikely to facilitate. For the past decade yield and CEFs has almost been unanimous. For example, there are now only three equity funds currently showing a market yield under 5%. In the tables below we have summarized the last decade of CEF IPOs from December 31, 2003 through December 31, 2013.
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What does the future hold for closed-end funds? We think that CEFs in the future will include less yield-focused endeavors, where leverage is applied for more capital appreciation goals than simply the goal of increasing the dividend yield of the underlying securities. We believe that investment objectives and portfolio managers which investors have no other way to access, other than through these new CEFs, will fuel demand for CEFs that are more about growing capital than only producing income.
Investors are generally disfavored with “Hedge Funds”, which we think are misnamed; not all Hedge Funds actually “hedge out” market risk, though there are still a good number that do state it as an investment objective. Hedge funds are actually just a pooled investment structure for accredited investors ($2M in net worth) where the portfolio manager can participate in the portfolio’s growth. They generally have a fee structure that looks like 2% per year and 20% of high water (new) gains. We think investors that had previously searched out this type of manager can find comfort and liquidity in a potential new generation of CEFs.
Why Alternatives Make Sense in a CEF Structure? It is simple, fixed capital allows for less liquid investments and no redemption pressures. This is exactly the type of investments that hedge funds have often used for clients. The CEF world needs great managers with ideas and investment mandates that are not available or ideal to ETF or open-end funds, to lead the way for this endeavor.
Roadblocks to Success and CEFA’s Advice: Three issues need to be addressed by the CEF community in our opinion. First, IPO loads or commissions need to be reduced or spread over a time period of six months to a year. Second, the SEC needs to allow Fund Sponsors to go from an investment idea to IPO in 45 days or less. Third we have to deal with the historical fact that most CEFs trade at a discount to NAV; discounts of -3% to -5% for bond funds and -5% to -10% for equity funds are common over time.
We think that if a financial advisor recommends a CEF IPO to clients, they should be able to be compensated with a fee schedule similar to a C-Share open-end fund, or 1% per year vs the 5% normal IPO load. Many advisors are now working on fee-based revenue. If they are rewarded when they select funds that do well, then the incentive of steadier revenue could lead to more successful IPO recommendations by advisors and consequently, more clients might have a positive impression of both the IPO process and the results of investing in them. We have found this to be the exception not the rule in CEFs, where according to a study we did last year, if you wait about 9 months to buy a CEF that IPOed, you have 8% better returns on average than buying on the IPO. The article is available on our blog (www.CEF-Blog.com).
We would like to see regulators allow Fund Sponsors to shorten the turnaround from N-2 filings (public notice of intent) to IPO date (CEF creation), which we have found, in our experience, to be six months. The equity and credit markets can change very quickly, and we think better ideas will be offered to investors if ideas can come to fruition quicker.
Regarding discounts, we usually do not have an issue with funds that trade roughly between a -10% discount and NAV. We also generally don’t like buying above a 3% premium. Of course this is driven by our past experiences in closed-end funds. We also don’t see much room for change when a CEF IPO offers a strategy available in other 40 Act options (open-end / ETF) or is just leveraging income.
Pathway to Change: We believe the current group of CEFs that are classified as business development companies (BDC) give some light into this future. Most investors know little about the 44 closed-end management companies organized under the BDC structure. They possess the fixed capital, active management and investor liquidity, CEFA’s definition of a CEF. Our firm has spent the past few months working to understand these funds better. In fact we will be adding coverage of them to our CEF Universe data in March of this year. They often support premiums, but also generally offer yield similar to regular CEFs. They are all quite different from each other and as they file with The SEC like a common stock vs. CEF filings. We believe most investors look at them as a stock and not an investment company.
However, they are not simple equity income or bond funds in operation. We suggest more investors and fund sponsor look at the sector to help take the CEF structure (which has been trading on the NYSE for over 120 years) towards their future. There is also one current regular CEF that shows us what alternative CEFs might look like: NexPoint Credit strategies (NHF). They were essentially a loan and credit fund that in early 2013 starting adding equity exposure when they saw excess risk in the bond market. They were lucky to have a wide investment mandate which allowed this change. In fact if you visit their website(www.highlandfunds.com) they say, “Highland Capital Management is a registered investment advisor serving financial advisors, institutions and individual investors seeking registered alternative investment solutions.“ We were fascinated by this fund last year and ended up doing an interview with their COO, Brian Mitts, which we published on our blog in January of 2014.
We are excited about the next 120 years of CEF advancement and look forward to doing our part to help create and track these options for investors and for our clients. Please let us know what you think and do your part to help the CEF industry evolve.
The views and opinions herein are as of the date of publication and are subject to change at any time based upon market or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed.