When the bull market was peaking in the late 1990s, new issues of closed-end funds virtually dried up. According to Thomas J. Herzfeld Advisors, a Miami-based closed-end fund specialist, only one closed-end fund came to market in 2000, raising just $300 million. This led many market observers to suggest that the industry was becoming irrelevant. That call, however, turned out to be greatly exaggerated. Ironically, it was the subsequent collapse of stocks and interest rates that revived this moribund industry. A new generation of closed-end funds began targeting investors looking for steady income streams.
In 2001, 37 new closed-end funds came to market, led by municipals, raising nearly $6 billion. In 2002, 79 issues worth $16 billion were issued, buoyed by a newfound interest in preferred stock funds. Then 2003 and 2004 averaged 50 deals each year, boosted by more preferred funds and alternative equity products that generated about $26 billion, respectively. According to Cecilia Gondor, executive VP at Herzfeld, the pace is continuing this year: During the first half of 2005 alone, there were 31 deals worth more than $14 billion.
Does that mean the industry’s structural anomalies, which have troubled investors, have disappeared?
No. Their market values will always deviate, sometimes significantly, from their net asset values. This is unlike open-end funds, in which every dollar you invest [less any acquisition and managerial expenses] actually gets you ownership of a dollar’s worth of the fund’s securities.
Take the closed-end China Fund (CHN). On July 22, 2005, it was trading at $28.77 per share, but its underlying securities were worth only $25.44. That meant new investors were paying a 13% premium to get into the action. And good action it’s been. Over the past year, the fund’s market value appreciated 29.2%, according to Barron’s weekly listings of closed-end funds. However, according to Lipper, Barron’s source, the fund’s premium had soared beyond 41% late last year. So if you had bought shares in December 2004, you’d be deep in the red.
This deviation between NAV and market value can also work in investors’ favor. Take the Korean Equity Fund (KEF), which rose 46.5% over the last 12 months. During that time, its discount of more than 14% narrow to below 6%. In fact, the fund has been enjoying a long-term improvement in the discount, which peaked in November 2001 at more than 21% but has been correcting ever since.
To help attract underwriters as well as investors, many closed-end funds committed themselves to managed distributions–a regular payout, measured as a percentage of NAV, which topped out as high as 10%.
Certainly the concept is attention grabbing. However, it doesn’t take an MBA to realize that such funds could suffer from capital erosion to meet such commitments. But some funds and their shareholders have actually thrived under such arrangements.
Take the Blue Chip Value fund (BLU), which started in 1987 with an NAV of $9.27. It subsequently adopted a managed distribution of 10%. According to Don Cassidy, senior analyst at Lipper, the fund’s NAV had declined to $5.64 as of the end of June 2005. However, because of the fund’s ability to meet its managed distribution, aided through leverage, and helped by a premium that now stands at 14.6%, the fund’s historic annualized returns exceed 9%.
Closed-end funds also earned a sour reputation from the financial hit investors almost always take when buying initial public offerings of a fund. While distribution fees have come down a bit since the 1990s, Michael Porter, senior research analyst at Lipper in New York, explains that the typical closed-end fund coming to market at $20 will see its initial net asset value set at $19.10 because the underwriters are taking a $0.90 fee.
“How IPOs can still be sold under this arrangement,” queries Porter, “is the million-dollar question.” But he believes that the recent revival in closed-end funds, despite the quirkiness in which they first come to market, is due to new income-oriented products offering investors intriguing alternatives to traditional investing that otherwise would be difficult to come by. A key means that helps them achieve these above-market income flows is leverage–a feature unavailable to open-end funds.
Leverage is achieved when a fund borrows against its assets. While the degree of borrowing varies widely, it is typically around 30% to 35%. This means funds can have a third more income-producing assets working for it, which can transform a 4.5% income security into a 6% yield.
This year has seen the issuance of multi-strategy funds seeking to deliver steady income flows. They rely on various assets, many of which make up the individual funds discussed below:
Master Limited Partnerships
Alex Reiss, a senior closed-end fund analyst at Ryan Beck & Company, with $18.5 billion of assets under management, believes that while closed-end funds are not a distinct asset class, they should be looked at as a means of improving allocation strategy. For instance, he’s keen on master limited partnerships to enhance energy exposure. “They aren’t bets on commodity prices,” Reiss explains, “but investments in gas and oil pipelines and other energy infrastructures that generate toll-like revenue as resources flow through them.”
Last year, four MLP funds came to market, raising $1.6 billion. With average yields of about 6%, the group has enjoyed a solid year so far, up an average of 10.6% through July 7. Despite its rather high expense ratio of 2%, Tortoise Energy Infrastructure [TYG] is pacing the industry, up nearly 20%, trading at a 7.8% premium, well above the group’s average of 1.2%.
Corporate Loan Funds
Mariana Bush, closed-end fund specialist at Wachovia Securities in Washington, D.C., likes prime rate, a.k.a. corporate, loan funds, which are made up of debt issued by below-investment-grade companies. “But they are generally more secure than high-yield bonds,” Bush explains, “because they are higher up the capital structure than bonds; i.e., first-lien loans will be paid off ahead of nearly all other debt.”
Further, their NAVs are generally less volatile than high-yield debt because their income adjusts on average every two months. Dividends are based on 30-day LIBOR plus 200-400 basis points–depending on credit quality.
Loan funds were trading up to a 5% premium in early 2005 as costs of borrowing remained relatively inexpensive, portending the bottoming of default rates at 2.2% in May. However, Moody’s believes default rates will rise moderately over the next several years as the cost of borrowing increases along with the Fed Funds rate. This has helped transform premiums into discounts ranging down to 9% as of the end of June.
Bush believes institutional selling has driven down market prices, as money managers liquidated carry trades that are proving less profitable as short-term rates rise. But she arguees that “while increasing defaults may push down NAVs, investors should be rewarded by rising yields as short rates continue to increase, boosted further by discounted pricing.”
Among the more attractive loan funds, says Bush, is the $1.46 billion Van Kampen Senior Income Trust (VVR). This trust invests exclusively in first-lien loans, which Bush believes will outperform higher-yielding, lower-structured debt during a rising rate environment. It doesn’t have the highest yield [6.2%] or three-year annualized returns [10.8%] as some other funds, but has very low volatility [5.8%], a below-average expense ratio of 1.59%, and is trading at a 5.7% discount, helping to mitigate risk.