Closed-end funds could also be possibility for retirees looking for portfolio revenue
If you’re trying to generate portfolio income away from the stock market, closed-end funds may be part of a solution.
With yields near zero on U.S. Treasurys, retirees’ once-standard strategy of safely generating income at a rate that beats inflation isn’t working so well. Yet many retired investors still want to keep some money away from stock market volatility so they don’t end up in the situation of needing to sell on the dips — or during a bear market — when they need cash for living expenses.
“It’s a struggle out there,” said certified financial planner Ken Nuttall, chief investment officer for Black Diamond Wealth Management of New York. “We’ve got clients in their retirement years looking for income.”
Closed-end funds, which have been around since the late 1800s, come with more risk than Treasurys yet also can provide decent yields that may have a place in the income portion of your investment portfolio.
At year-end 2019, 500 closed-end funds had total assets of $278 billion, according to the Investment Company Institute. That compares to $21.3 trillion in mutual funds.
Unlike traditional mutual funds, however, closed-end funds generally issue a set number of shares at their creation — similar to a company that goes public — and trade on the open market like a stock. This means that, while the share price might be related to the performance of the fund’s underlying assets, it is based on investor supply and demand.
Thus, closed-end fund shares can routinely trade at a discount, or below their so-called net asset value (the bottom-line value of the fund’s assets divided by the number of outstanding shares). Or, they can trade at a premium (above that NAV).
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Much of the appeal of a closed-end fund rests in being able to purchase shares at a discount when there’s the opportunity for growth. For example, if a certain stock sector has been beaten up due to sentiment, a closed-end fund that invests in that sector may be trading at a price lower than its NAV, making it a bargain way to get exposure to that segment of the investment world.
Like many traditional mutual funds, they are actively managed — meaning experts are at the helm picking the underlying investments, whether stocks, bonds or other investments. And, many generate income that’s distributed on a monthly or quarterly basis. Most assets (61%) in closed-end funds are invested in bonds, according to the Investment Company Institute.
These funds also may put their assets in less-liquid investments, such as very small companies, municipal bonds that aren’t widely traded or emerging market securities.
“One thing we like is that you can get esoteric assets that you wouldn’t be able to get in a mutual fund,” Nuttall said.
Many closed-end funds use leverage, subject to regulatory limits, to juice their returns. That is, they can borrow money to invest. However, leverage also means that losses can also be exacerbated.
“That’s something we take into consideration,” said CFP Robert Finley. “When you look at (an investment) that’s really beaten down, we’re more open to leverage.
“But in typical times, we avoid leverage because doing so provides more protection on the down side,” said Finley, a principal at Virtue Asset Management in Chicago.
What it will cost you
As for cost, there’s a wide range.
“If you look at a leveraged closed-end fund, the expense ratio could be over 2%,” Finley said. “But some of the muni-bond funds we use are 0.3% or 0.4%. It differs by sector and asset allocation.”
Generally speaking, you have to pay taxes on any income or capital gains distributed to you as a shareholder of a closed-end fund. When you sell shares of the fund, you may have either a taxable gain or a loss, depending on the price when you purchased.
And, toward the end of the year when investors do tax-loss harvesting — selling investments with a loss to offset gains elsewhere — there’s a chance that some closed-end funds could be trading at deeper discounts.
“Depending on how the year went, closed-end funds tend to get sold,” Nuttall said. “This tends to widen the discounts.”
By the beginning of the next year, however, that discount tends to diminish, he said.
While it depends on the client and specific situation, it may be worth limiting your investment in closed-end funds to 5% of your income portfolio, Finley said.
As for the yields generated, it depends on the fund.
“A muni-bond closed-end fund may be 3%, but one in master limited partnerships might be mid-single digit or higher,” Finley said. “It depends on what asset class you’re purchasing.”
And, like any investment, you should do your research on the fund and its managers’ track record.
“At the end of the day, you need to know what you’re owning,” Nuttall said.