May 18, 2011

Closed-End Funds Present Investing Opportunities, and Pitfalls

April is in the books, and the markets continued their upward climb after March’s mild and short-lived sell off. Aside from temporary fluctuations, closed-end funds measured by the RiverNorth Closed-End Fund Index have consistently turned in positive performance, returning more than 25% since last June.

Looking ahead, several events loom on the horizon: the end of QE2, continued Middle East turmoil, inflation fears, rising energy costs, concerns about interest rates and the ongoing effects of the disasters in Japan. While the worldwide economic repercussions of these events remain to be seen, their effects on closed-end funds should be watched and could present attractive investment opportunities.

Rising short-term interest rates is a risk calling for extra attention from closed-end fund investors.  The capital structure of closed-end funds is directly affected by changes in short-term interest rates, as closed-end funds often use leverage to enhance the returns and yield of their portfolios. Approximately 73% of closed-end funds currently utilize some form of leverage.

The cost of the leverage is often floating based off short term interest rates and if rates rise, the cost of leverage increases and drags on performance.While the Fed has clearly stated it intends to keep interest rates low for an “extended period,” closed-end fund investors should be aware of the impact of short-term interest rate changes.

Before the Fed last began to raise rates, on June 30, 2004, taxable fixed-income closed-end fund discounts widened out 9.25% in just over a month. Anticipation of rising interest rates was a primary driver of the drastic discount widening seen in 2004. No one knows exactly when the Fed will choose to raise rates, but the prospect of rising rates is garnering a significant number of headlines and presents a risk worth monitoring.

April Closed-End Fund Sector Roundup: Real Estate a Leader, Non-U.S. Equity a Laggard

The RiverNorth Closed-End Fund Index’s positive month was driven by outperformance in real estate 

and international asset classes. Real estate closed-end fund prices were up 5.49% in April, while global equity funds were up 3.67% on a price basis and 4.81% on a NAV basis (resulting in a 1.08% discount widening).

Emerging market income also returned 3.47% on a price basis.  Despite the strong performance of non-U.S. asset classes in April and March, they are still recovering from weak returns in January and February. Non-U.S. equity closed-end funds lag U.S. equity closed-end funds by 9.31% year-to-date. U.S. equity closed-end funds have returned 9.31% year-to-date compared to 0% for non-U.S. equity and 3.90% for emerging market income closed-end funds over the same period.

April Closed-End Fund IPOs:

  • ING Investment Management launched the ING Emerging Markets High Dividend Equity Fund (IHD), which raised $385 million in an initial public offering. The Fund will invest in dividend paying equities, primarily of issuers in emerging market countries.

In the overall closed-end fund market, the RiverNorth Closed-End Fund Index was up 2.01% in April and is up 7.11% year-to-date through April 30. Discounts on the RiverNorth Closed-End Fund Index widened 0.84% in April and currently stand at -3.45% on average at the end of April.

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