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Closed-End Funds: Democratizing Alternative Investment Strategies

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Once the province of institutional investors and the ultra-wealthy, alternative investments have gone mainstream, drawing significant interest from all corners of the investing world.

Seeking growth, yield and diversification, individual investors are following the path pioneered by institutional investors in pursuit of new, more tangible investment opportunities, particularly after traditional asset classes were roiled in the global financial crisis. Flows into the alternative asset category show this; a 2015 McKinsey article notes that global alternative assets under management grew at a 10.7% annualized rate between 2005 and 2013, twice as fast as traditional investments. 

The appeal to investors is straightforward: enhanced portfolio diversification by exposure to investments whose risk and return characteristics are historically uncorrelated with traditional investments, along with the potential to produce higher returns than available in a more traditional investment universe.

Evolving With Investor Goals

Despite the lure of potentially higher returns, it is structural forces, not performance trends, that are fueling the popularity of alternative investments. Many investors and their advisors have moved on from a strict focus on alpha generation 1 and instead are pursuing investment outcomes such as absolute returns. They are also increasingly looking to alternatives to deliver on other crucial outcomes like inflation protection and income generation.

As a result, lines have blurred between traditional and alternative asset classes as investment managers battle for an overlapping opportunity set. But not all investment vehicles are created equal – some traditional investment managers have struggled to shift from a relative-return approach that has defined their business for decades. On the other hand, not all alternative specialists are equipped to build and manage investment products for the masses. Thus, the market for alternative investments remains fragmented.

Closed-End Funds: Delivering Alternatives Exposure

As investment managers scramble to launch the latest alternative portfolio, typically only to an ultra-high net worth audience, there exists a perhaps less obvious but well-established option for delivering alternative investment strategies: closed-end funds. The closed-end fund structure is well suited to offer alternative securities and strategies. Lacking daily inflows and outflows, their relatively stable capital structure makes CEFs particularly good for investing in niche, less liquid assets that may be ill-suited for other investment structures because they are difficult to sell quickly.

CEFs can also invest in assets that may be otherwise unavailable to individual investors, or in some cases greatly simplify the way investors can access more complex assets. In effect, they can democratize the process of investing in alternative assets. Unlike both institutional and retail alternative products, CEFs do not have a minimum initial investment requirement, and they do not have the stringent lockups that private limited partnerships usually require.

A closed-end fund is an investment structure – not an asset class – with shares that trade like a stock on the open market, where their market prices may be higher or lower than their underlying net asset value or NAV.  Closed-end funds generally raise money for investing only at inception, offering a fixed number of shares in an initial public offering.  Since they do not need to manage inflows and outflows of assets like their open-ended cousins, CEFs can generally remain fully invested. A CEF portfolio manager can commit to a strategy and take a long-term view, rather than sell assets to meet withdrawal demands or buy assets to meet targets when new deposits arrive.

Alternative Strategies, Not Just Assets

For decades, investments in private and listed real estate, infrastructure, less liquid or illiquid credit, certain currency strategies or public-private investment partnerships were exotic outliers, inaccessible to a mass investing audience. While these alternative asset classes remain complex, potentially illiquid or potentially difficult to value, with higher volatility and risk of loss than traditional investments, they are easily accessible and tradable in the form of CEF shares. Open-end mutual funds can invest only 15% of their portfolios in illiquid securities. Closed-end funds do not have this restriction, making them attractive vehicles for investing in alternative strategies.

In addition, CEFs can also offer alternative investment strategies, such as the use of leverage, a combination of long/short strategies, option overlays and managed futures. These, in effect, enhance both the diversification and potential return of alternative investing strategies.  About four in five CEFs employ leverage already, within the modest limits of the Investment Company Act of 1940 2.  Leverage acts as a magnifier, making investment returns more volatile – higher highs, lower lows – but historically has boosted returns over longer time periods.

So how can advisors help clients interested in alternative investments and strategies wisely select closed-end funds?

When weighing alternatives options in the CEF market, remember these key tenets: CEFs are typically managed to provide persistent income or cash flow, and can offer attractive returns while providing portfolio diversification through access to alternatives due to their ability to invest in less liquid asset classes. Investors may benefit from the flexibility portfolio managers have in this structure, which is particularly important for those who are interested in accessing alternatives.

As always, advisors should consider an investor’s current holdings when determining the size and nature of a potential CEF investment. Like any other investment, it should complement an existing income portfolio and align with an investor’s overall goals and strategy.

1.Alpha generation is an investment’s excess return relative to its benchmark index return, attributed to active management of the investment.

2. Source: Morningstar, 12/31/2016


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