Do obsucure investments, like closed-end Funds add enough income to justify adding them to a portfolio?
As yields have all dropped since 2011, a search for income to off-set these dropping interest rates has led investors to try desperate yield-generating strategies and high-risk investment vehicles, like CEFs. Sometimes the outcomes of these seemingly victorious investment choices are actually ultimate defeat (pyrrhic victories). This has happened to investors seeking dividend, multi-income, annuity strategies, and CEFs, to name a few. A “closed-end fund” isn’t all bad, but it is a security selection that we repeatedly hear about from clients and prospects alike. We caution you with the words from King Pyrrhus during his victorious battles in Rome in 280 BC when he stated: “If we are victorious in one more battle with the Romans, we shall be utterly ruined.” There are times when the cost incurred for a victory creates ruin in the long-run. Therefore, close attention should be paid to hidden costs.
In our ongoing “no free lunch” series, we address the pitfalls of Closed-End Funds (CEFs). These securities should only be bought with an understanding of the true risk and cost of the underlying investments. Closed-end funds may look like other securities, but closer examination can reveal a more tumultuous investment than originally seen.
At first glance, closed-end funds seem like a variation of a mutual fund or the less expensive cousin, an exchange-traded fund (ETF). Investopedia defines it as a “portfolio of pooled assets that raises a fixed amount of capital…has a professional manager overseeing the portfolio…it trades like equity.” So far, it is roughly similar to other funds, especially ETFs. Except, that similarity ends fast, beginning with their seemingly low price.
Related reads: What is “Free” Investment Management?
The Reason for Selecting CEFs
The discount between the fund’s assets and its trading price is one of the first ways these funds tempt investors who are looking for yield. In contrast, when you buy a common stock (not penny stocks), a mutual fund, or an exchange-traded fund, you can be certain that the price that you are paying represents a close approximation to the value of that investment. This is not true for closed-end funds. A quick glance at a closed-end fund, such as a common fund offered by Nexpoint, the Strategic Opportunities fund, will quickly show why this advantage isn’t an advantage at all. At the time of this blog writing, the underlying value of this fund was $21.83 (the “NAV,” in industry terms) while it is trading at $18.63 in the market - a whopping 15% discount. For any normal fund, that would be a quick buy signal. However, a look at a website dedicated to these funds, cefconnect.com, shows that the largest discount offered on this fund was approximately 24% over the last year! The point is that a fund trading at a discount isn’t necessarily a deal and could potentially lock in a significant loss (roughly 10%) if you accept a low discount rate! As with most investors who bought CEFs, however, yield is the prime reason for making this purchase, which we will examine next.
That same fund we examined above (NHF) pays a juicy 12.9% yield according to yahoo finance and TD Ameritrade. By comparison, stocks are paying about 2%, and the bond market is paying about 2.7%. That’s about 5 to 6 times more! Now that 10% loss doesn’t matter anymore, right? Wait a minute, a quick glance at this years’, and up to 5 years returns show either negative or measly 1.5% total return. If NHF pays almost 12.9%, then why is the total return exceedingly low? The simple answer is that closed-end funds have three very important, but hidden quirks.
First, the yield does not reflect the income being produced by it. In layman’s terms, the fund managers can declare a certain yield without any dividend to back up that return. I.e., they are simply returning your own capital. As an example, if a CD paid a 100% yield, but simply gave you all of your money back, the actual paid out interest is 0%, not 100%. The distribution rate and true yield are not the same.
Second, the increased yield is garnered through higher risk borrowing. The borrowing can be uncomfortably large sometimes. Again, a quick look at http://www.cefconnect.com will show that it doesn’t make that 13% yield it paid out until recently. Instead, it makes a lower yield and borrows to invest more than 100% of its value. This borrowing means that it has a higher risk than a traditional fund. This leads to the third point, cost.
The management fee for this fund, including interest expenses, is about $3,250 per $100,000 annually. A plain vanilla fund, SPY, charges about $90 per year – a 97% savings. Nexpoint’s 10-year track record shows that its risk is about the same as the market, represent best by “SPY.” Also, a look at its track record over ten years, shows that if the high fee was added back, its return would roughly equal the stock market, which returned 14.6%, over that same time. So why pay these high costs, if you can get the same returns for less?
Would you rather keep the high costs, avoid the mental gymnastics, and get an almost identical return?
This is not to say that all closed-end funds are bad. To counter every point above, there are cheap CEFs, CEFs with no added lending risk, and many CEFs have begun reducing their yields to match their investment payout. Bottomline, like any other investment, they come in many forms. However, as we will explore in detail in upcoming articles, the further you travel into obscure investment vehicles and products, with CEFs as just one example, the more aware you need to be to avoid uncomfortable and unexpected results. In the example above, an extra $3,250 could have been saved over the last year by simply investing directly in the market, without all the bells and whistles (noise) added by the closed-end fund structure. We intentionally found an extreme example to make the point. Just as King Pyrrhus discovered in his battles 2,300 years ago - when looking to achieve a victory (higher yields), the consequences of that victory (higher risk, lower returns, much higher fees) might cause you to lose the war.
The answer to the question at the beginning of this blog, “can closed-end funds add enough yield to justify inclusion in a portfolio,” is yes. More important, to truly measure what you bought – as seen above- is complex for CEFs. A better approach is to treat any investment product in your portfolio as merely playing the role of a pawn in your long-term goals. Even more critical, a well-developed plan won’t guarantee a positive outcome but it will increase the probability of achieving your goals. Instead, this article seeks to arm you with the knowledge you need to make sound financial decisions. Meet with your advisor regularly. He or she will best match your investments to your goals and objectives, and work to produce the income you need at the cost and risk in which you are comfortable.
Stay tuned for the next blog in this no-free-lunch series.
 Pyrrhic victory. (2019, August 06). Retrieved from https://en.wikipedia.org/wiki/Pyrrhic_victory
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Lighthouse Financial Services, Inc. is a Registered Investment Adviser with the Securities and Exchange Commission. Registration does not imply a certain level of skill or training. The examples provided in this blog are illustrative only and meant for educational purposes. Do your own due diligence or seek the advice of a trained professional before making any investment decisions. Data mentioned in hyper-links may change overtime, keep in mind the date of this initial post and its subsequent re-posting. This blog does not suggest or recommend any mutual fund or ETFs. The specific funds mentioned in this article are for educational comparisons only to demonstrate differences.