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11 Jul 2019

CLOSED-END FUNDS: FROM ALL ANGLES By Charles Paikert

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Post by MoneyRadio Staff

From risk to retirement income, this 10-part series from Financial Planning explores what financial advisors need to know about these funds.

FEATURE 1

The challenges of explaining closed-end funds to clients

Help them understand distinctive features, especially pricing and leverage.

By Charles Paikert

Given the wide range of complex financial options, clients need all the help they can get. That means financial advisors may need to brush up on some asset classes that aren’t currently in the spotlight.

For example, closed-end funds aren’t a top-of-mind portfolio selection for many clients — although they hold about $275 billion in assets. But these funds can help clients achieve diversification and come with a reliable and attractive income stream and the potential for appreciation.

There are misconceptions about some of the more distinctive features of the asset class, however.

The use of leverage is commonly misunderstood, says Devin Ekberg, chief learning officer for the Investments & Wealth Institute. “Closed-end funds can introduce leverage in ways that mutual funds and others can’t,” he says. “For many people, the thought of funds using leverage triggers memories of banks in 2008 and the financial crisis. But that’s not the right way to view it.”

Levels of leverage used by CEFs “are much lower than what people might expect — usually not more than 30%,” Ekberg points out. According to the Investment Company Institute, the average leverage ratio for bond funds stood at 28% last year; for equity funds the leverage ratio was 22%.

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Unlike open-end mutual funds, closed-end funds can use leverage to widen investment exposure and potentially boost returns, borrowing at rates pegged to LIBOR or the Fed funds rate for taxable funds and the SIFMA index for tax-exempt municipal funds.

Because CEFs don’t continuously issue or redeem shares, they can remain fully invested, don’t have to hold large amounts of cash and have more freedom to use leverage, potentially resulting in higher returns.

“The extra risk closed-end funds are taking with leverage can certainly benefit investors on the upside, but of course they can be penalized on the downside if things don’t work out,” says Josh Duitz, senior vice president of global equities at Aberdeen Standard Investments.  Consequently, advisors should make sure clients understand the risks, Duitz says.

 Closed-end funds’ use of leverage can be relatively safe “if the underlying assets are of high quality and have volatility of around 3% to 4%, commensurate with stable assets such as high-quality bonds,” says Nathan Sonnenberg, CEO of Wealth Management Consultants in Tysons Corner, Virginia.

Funds investing in short-term, high-quality fixed-income such as municipal bonds or investment-grade corporate bonds can usually take credit risk out, Sonnenberg says. But he warns that high amounts of leverage used in funds investing in master limited partnerships or real assets “can be a toxic, dangerous combination.”

PRICING ISSUES

Closed-end funds have a unique pricing mechanism that may hinder some advisors from using them in portfolios while prompting others to take a risky approach.

Unlike mutual funds, CEFs don’t issue new shares after their initial public offering. When shares trade, their price is based on the net asset value of the portfolio. But demand may be greater — or less — than the actual value of the underlying securities. When the purchase price is valued above the NAV, it trades at a premium; when it’s valued at less, it trades at a discount.

 “Because of the fluctuations of premiums and discounts, advisors think that closed-end funds are about market timing, but they’re not,” says Ekberg. “For most advisors’ clients, the priority should be distribution of income.”

For clients who can’t afford access to a hedge fund, a closed-end fund may be an option, says Ben Webb, director of manager selection, Balentine.

Simply trading at a discount is not a reason to pick them for client portfolios, says Ben Webb, director of manager selection at Balentine, an Atlanta-based wealth management firm.

“Buying a CEF at a discount adds one more risk to the investment, Webb says. “It may sound good, but there is not always a clear reason why a discounted price will close [to the value of the assets in the fund].”

INCOME BENEFITS

Once a closed-end fund is purchased, advisors should help clients monitor distribution of income.

Because CEF managers aren’t subject to the redemption pressure faced by mutual fund managers, they are not forced to buy or sell when they don’t want to, Duitz points out. As a result, advisors can help clients “plan how much income they will be receiving over a period of time,” he notes.

What’s more, the ability to distribute returns more equally throughout the year makes income more predictable and can help clients manage their taxes more efficiently, Ekberg points out.

But income is not guaranteed for the life of the fund, according to Duitz. “There is a market risk that comes with the underlying investments in the fund,” he says. “If the value of an underlying asset goes down in the market, the fund’s dividend can be cut. A CEF is not an income stream for perpetuity.”

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The biggest risk investors face is a closed-end fund that is not managed well.

Devin Ekberg, chief learning officer for the Investments & Wealth Institute
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Advisors should also keep in mind that closed-end funds’ ability to purchase illiquid assets is another reason the funds can generate higher yields.

Indeed, a good closed-end fund can mimic investing strategies used in limited partnerships and hedge funds.

“For clients who want access to an MLP or a hedge fund but can’t afford it, a closed-end fund may be an option,” says Webb. “It can be a tool on the liquidity spectrum for advisors.”

But the freedom to invest in illiquid assets comes with caveats.

“The biggest risk investors face is a closed-end fund that is not managed well, where managers are overpaying for assets and not handling risk well,” Ekberg says. “Advisors should evaluate a fund’s track record, its underlying holdings and the composition of its income distribution.”

https://www.financial-planning.com/news/closed-end-funds-from-all-angles?utm_campaign=Jul%2011%202019-portfolio&utm_medium=email&utm_source=newsletter&eid=1fd5b60c246848b677825c3730fbfbb2#group-new-installment-every-two-weeks-iRmWkPzbxI

This article is suggested reading by Secured Financial Services, LLC and President and Chief Executive Officer of Secured Financial Solutions, LLC, Anil Vazirani. Please visit https://secured-financial-solutions.com/

Retire and Stay Retired Safe! Smart! Secure!

Based in Scottsdale, Arizona, Secured Financial Solutions is one of the leading financial service firms in Arizona, catering to the financial planning needs of retirees and pre-retirees.

One of the benefits you can count on when working with one of our financial advisors is an outstanding personal relationship with an advisor. As a client, you will deal directly with a financial advisor who will take the time to understand your situation, objectives, estate planning, and retirement planning needs as well as your risk tolerance. We work directly with other advisors as well as CPAs, attorneys and trustees, to ensure that the investments we make will align with your estate plans, and that you are not faced with heavy tax burdens.

You can expect Secured Financial Solutions to develop comprehensive solutions to your complex wealth management and estate planning needs. Our one-on-one approach helps you achieve your financial planning goals, including maximizing your estate, retirement planning, minimizing your tax obligation, and continuing your family legacy. Our investment advisors will work with your CPA, attorneys, and other trusted professionals to help you make intelligent choices that align with your financial and personal goals.

This article is suggested reading by Secured Financial Services, LLC and President and Chief Executive Officer of Secured Financial Solutions, LLC, Anil Vazirani. Please visit https://secured-financial-solutions.com/

Retire and Stay Retired Safe! Smart! Secure!

Based in Scottsdale, Arizona, Secured Financial Solutions is one of the leading financial service firms in Arizona, catering to the financial planning needs of retirees and pre-retirees.

One of the benefits you can count on when working with one of our financial advisors is an outstanding personal relationship with an advisor. As a client, you will deal directly with a financial advisor who will take the time to understand your situation, objectives, estate planning, and retirement planning needs as well as your risk tolerance. We work directly with other advisors as well as CPAs, attorneys and trustees, to ensure that the investments we make will align with your estate plans and that you are not faced with heavy tax burdens.

You can expect Secured Financial Solutions to develop comprehensive solutions to your complex wealth management and estate planning needs. Our one-on-one approach helps you achieve your financial planning goals, including maximizing your estate, retirement planning, minimizing your tax obligation, and continuing your family legacy. Our investment advisors will work with your CPA, attorneys, and other trusted professionals to help you make intelligent choices that align with your financial and personal goals.