There are currently a number of fund-based options available to investors looking for yield. In addition to traditional open-ended mutual funds, investors are also turning toward closed end funds (CEFs) and exchange traded funds (ETFs) to generate yield, including in the high yield bond market. Both CEFs and ETFs have continuous trading and pricing throughout the day, making them very liquid options for investors. While CEFs tend to be actively managed, there are both index-based options and actively managed options in the ETF space. However CEFs and ETFs have some dramatic differences that investors should consider when making a decision as to what structure is best for them.
A closed end fund has a set number of shares, raising initial capital through an IPO. With this structure, shares are not created or redeemed based on market demand, but rather shares are purchased or sold within the market, and the fund’s share price reflects that demand. An ETF on the other hand, meets market demand with the creation and redemption of shares as needed so market demand can have less of an impact on trading price, though this means the number of shares and asset base is in fluctuation based on demand.
ETFs are fully transparent, with holdings disclosed on a daily basis. With CEFs, certain portfolio details, including holdings, are often only disclosed on a monthly, quarterly or semiannual basis.
ETFs are generally considered tax efficient as the creation and redemption of shares between the market makers and the fund can be done “in-kind,” whereby no taxable gain or loss is generated for the shareholder. With closed end funds that do not have this creation and redemption option, capital gains generated within the fund have to be paid out at year-end, creating a tax obligation for shareholders.
NAV Premiums and Discounts
With the ability to create and redeem shares to address market demand, ETFs generally trade fairly close to their NAV. However, with CEFs, the value of the fund is based on demand. If investors are buying up and increasing the demand for shares, the fund price would be driven up and it may trade at a premium to the fund NAV. However, if there is sell pressure that may cause the fund to trade at a discount to NAV. In reality, most CEFs trade at discounts to their NAV, in many cases by 5-10%. For instance, in Q2, the average CEF was trading at a -8.97% discount to NAV and taxable fixed income had an average discount of -10.43% at June 30th.1
Investors may look at these discounts to NAV and feel they are getting a deal—they are buying into a fund a price less than the underlying assets are worth. That may well be true, but it doesn’t necessarily mean that ultimately that value will be realized. Just like any stock with a fixed number of shares, market demand plays a huge part in the share price. So if there is not enough demand to drive the market forces to close the gap between the NAV and the market price, the fund may remain at that discount for an extended period, or the discount may even widen. We’d compare this to any sort of “value based” stock investment—investors are hoping that the market will ultimately realize the underlying value of the securities or the company and drive the share price up, but at the end of the day you are dependent on market forces. For instance, in some cases with high yield closed end funds we see discounts upwards of 10-15%. So when you are investing in some of these closed end funds that trade at large discounts to NAV, investors need to recognize that you are not only making a bet on the underlying assets but also that market forces will narrow the discount or at least hold it steady. Likewise, with ETFs, the discounts and premiums are dramatically narrower, thus investors or primarily making investment calls on the underlying assets.
Use of Leverage
Another thing to keep in mind when investing in closed end funds is that many of them use leverage, which can be upwards of a third of the total portfolio value. While leverage can be effective in increasing the distribution/dividend yield, leverage can also magnify fluctuations in the NAV and increase the underlying risk of the fund, as well as increase the cost of the fund. And another thing to keep in mind, if you expect interest rates to rise, that could well drive the cost of leverage higher and compress the ultimate net return and yield generated on the assets purchased with the borrowed funds. While some ETFs use leverage, it is only utilized in selective, leverage specific ETFs, not broadly used within the ETF space.
Fees in closed end funds not only include the basic management fees and fund expenses as you would see with ETFs, but also the cost of any leverage used, so this additional component must be included in assessing the total cost of the CEF.
Many tout the ability for closed in funds to invest in illiquid securities as a benefit. By the Investment Company Act of 1940, open-end funds and ETFs are limited to 15% of the portfolio in “illiquid” securities, while closed-end funds do not face that same restriction and are able to invest a larger portion of the portfolio in illiquid securities. While some investors may see this as a positive, we doubt all investors will. Even if a CEF is not forced to sell securities to deal with redemptions, their holdings are still priced on a daily basis and the fund NAV is reported on a regular basis, so if there is a market downturn having an outsized impact on the security pricing of this higher portion of illiquid securities that would be reflected in fund NAV.
Return of Capital
Some closed end funds have managed distributions/dividends as a fixed percentage of assets, and if there is not enough income generated during the period, then the fund can make up the capital shortfall with a “return of capital” included in the distribution. While this return of capital is not taxable and instead lowers the cost basis for the investor, a return of capital would reduce the fund’s net asset value and future earnings power. ETFs do not have fixed distribution rates, thus payout income generated and don’t face the return of capital issue.
We view active management as the best option for investing within the high yield market and traditional open-end mutual funds, closed end funds, and ETFs all offer investors a way of accessing actively managed high yield portfolios. However, each investment vehicle differs in terms of its structure, and investors need to understand the dynamics behind each structure. And as with all fund investing, we caution investors to review the underlying holdings of the portfolio. For instance, does a “high yield debt” portfolio include other assets, such as emerging market, government, or investment grade debt?
We see wise investors as those that take the time to understand what the own, be it the dynamics of the investment vehicle or the securities within it. Most relevant in looking at ETFs versus CEFs, investors must understand the positives, negatives, and additional risks that can come with outsized discounts and the use of leverage for high yield funds. For the high yield market, we view an active, unlevered ETF as a more straight-forward way to access the asset class. With the additional fund transparency, potentially more tax efficiency and simplified distributions, and much narrower discounts to NAV (thus not relying on the additional element of the market narrowing or keeping stable the discount), we would favor ETFs. Additionally, if an investor would like to lever up the assets, they can do that on their own rather than being forced to at the manager’s discretion within the portfolio.
1 Taggart, Mike, CFA, “CEF Market Overview,” Second Quarter 2015, Nuveen Investments, Inc., p. 1-2.