Ultimate Closed-End Fund Investing Guide: 14 Criteria For Safer Yield
Updated on July 19th, 2020
One of the many tools in the passive income investor’s toolkit is the Closed-End Fund (CEF). A closed-end fund is like an exchange traded fund (ETF) in that it trades throughout the day like a stock, but there are some major differences.
The money a closed-end fund manages is raised through an initial public offering (IPO) and the assets remains fixed, unless they offer more shares to the public through a secondary offering. This is in contrast to typical ETF or mutual fund where a creation and redemption process adds new funds on a daily basis, which are then spread across the asset base proportionally according to the fund weights.
When you buy a closed-end fund, you are buying it from another participant in the marketplace; the price is determined purely through supply and demand. It gives rise to a unique feature of CEFs where they can trade at a premium or a discount to Net Asset Value (NAV), which I discuss in more detail below.
Continue reading about the advantages and disadvantages of CEFs. There are many benefits, but there are also unique risks of closed-end funds that you need to consider before you add them to your passive income portfolio.
Why Buy a Closed-End Fund?
There are several reasons which make closed-end funds appealing.
Firstly, they often target niche areas of the market and they have no limit on the amount of illiquid securities that they can hold. This can provide you diversification and potentially Alpha if the fund manager has skill since CEFs are generally actively managed.
For example, PIMCO, a leading fund manager, has a lot of closed-end funds that scooped up thinly traded asset-backed securities shortly after the Great Financial Crisis (GFC) that were trading at a heavy discount to par value at the time. Risk is not great for illiquid securities since market participants are willing to sell at prices far below fair value. After PIMCO gorged on these assets, they performed enormously well over the subsequent years when market volatility cooled down.
Another potentially appealing reason for CEFs is that they can employ advanced strategies using derivatives, often swaps and option strategies like covered call overwrites. Of course, this can be a hindrance to the performance of the CEF if the manager isn’t skilled at employing these strategies, but the structure allows them to expand the toolbox.
Probably the most appealing reason for passive income cash-flow investors like myself, is that closed-end funds almost always offer a high yield. They do this through two avenues:
- Trading at a discount to Net Asset Value (NAV)
- Using leverage
Why Does a Closed-End Fund Trade At a Discount?
The closed end fund discount is one of the most appealing features of CEFs. In “A Random Walk Down Wall Street,” Burton Malkiel dedicates an entire chapter to this unusual price anomaly. With a closed end fund discount you can buy a basket of assets at 10-15% off by buying them through a discounted CEF instead of buying them directly in the market.
The theory is that the gap will eventually close and you’ll be able to capture that 10-15% free money, since one could arbitrage a risk free profit by buying the fund and selling the underlying assets.
Rarely does it work out that way in practice though. I recall reading about that concept in his book 20 years ago, and the discounts are still widespread today and still haven’t closed. Why might this be, you ask?
Well for starters, closed-end funds are less liquid than typical ETFs. They typically only have a few hundred million dollars of assets under management and don’t trade that many shares throughout the day. This lack of liquidity is a real cost when buying and selling assets, especially during times of market stress, and efficient markets practitioners like Malkiel would suggest that the discount is the true cost of the liquidity gap.
But there is more to the story.
Closed-end funds could buy back their own shares and it would be immediately accretive to the fund, but why don’t they do this? The answer is because CEFs usually pay out more income than the fund generates internally, so it is hard to come up with excess cash to buy back shares. There are some “interval funds” that buy back CEF shares from shareholders on a semi-regular basis but they aren’t listed on exchanges and they are usually credit funds that have maturing securities inside them.
The income gap is what makes a majority of CEFs poor investments. You must have a defined set of rules for determining if a CEF is worth buying.
Closed-end funds generally have a managed distribution policy that pays the same dividend, usually monthly, regardless of how much income the fund actually made. Investors always prefer stability so CEOs and fund managers alike prefer not to cut dividends and distributions, or else face the wrath of sales.
Closed-end funds use a combination of income, capital gains, and return of capital (ROC) to pay the distribution. The return of capital concept is very important when buying CEFs and those that have a lot of it should generally be avoided.
If the CEF is paying out more than their assets are generating, you are being paid back with your own money, after a management fee is first applied, of course. The value of the fund will continue to decline each year leading to a capital loss upon sale.
It might appear that you are getting a 10%, but if the CEF only generated 5% in income and capital gains, the extra 5% has to come from the assets in the fund. Discounts can widen because fellow investors are selling and expecting the fund to continue to lose value year upon year.
If the closed-end fund also trades frequently and has a lot of short term capital gains that will be passed down to the fund owners, this tax liability will be unattractive to owners, especially high marginal tax rate owners. They will sell out of the fund, putting downward pressure on the CEF share price.
Some CEFs perform secondary offerings for three reasons:
- They want to pump up their NAV for extra fees.
- They have had so much NAV destruction that the fund is no longer profitable to run, so they need to bring in assets.
- The fund managers see an opportunity that they would like to capitalize on with fresh capital.
If they offer shares at a discount, which is common, this is a penalty for existing owners and is dilutive. And if this occurs regularly, investors will catch up to the game and sell, further widening the discount.
Closed-End Fund Terminal Date Policy
There is no guarantee that a closed-end fund with a large discount will be squeezed back to NAV, therefore, you can’t just assume that the ones with the largest discount are going to be the best picks. In fact, during normal non-volatile times, a large discount is usually a prescient omen that the fund is going to lose a lot of value over the next year based on what we just discussed.
The only exception to this large discount rule is when a CEF has a scheduled termination date, or maturity date.
What this means is that the closed-end fund has a date where all the assets are scheduled to be liquidated and the assets returned to fund holders, unless a vote pushes the date out to a later time. Usually CEFs with these term dates don’t trade at big discounts because everyone is aware that free money will result as the date approaches. If the closed-end fund reaches its termination date and the fund still has a discount of 10%, for instance, it would be prudent for everyone in the fund to vote to close it so that they can capture that extra 10% risk free, then reinvest in something else or restart the fund.
The Z-score is a measure of the closed end fund discount or premium, relative to its own history and is more important than the absolute discount of a fund. If you compare two funds, one with a 20% discount and one with a 5% discount, you really can’t say which one is cheaper than average. The fund with the 20% discount might just be horribly managed and it loses 10% of NAV every year or might have a risky asset base.
That’s where the Z-score comes in, and it’s just like the normally distributed Z-score in statistics, computed as:
Z = (current discount – average discount) / standard deviation of the discount
Discounts and premiums do fluctuate with market conditions and it is helpful to know if it is trading at 1-2 standard deviations away from its average discount since they do have a tendency to revert to the mean.
Why Would a Closed-End Fund Trade at a Premium
Usually if the fund has a manager with a good reputation, and the assets they hold have a higher than average yield for the perceived risk profile. As mentioned before with the PIMCO closed-end funds, those assets they scooped up after the GFC are no longer seen as risky as they once were, and they have well above average cash flow yields. PIMCO also has a good reputation. Most of their funds trade at premiums.
Closed-End Funds Need to be Carefully Chosen
There is a little bit of an art to the selection process and a lot of details need to be considered.
You can’t just pick the highest yields and largest discounts without examining what the distributions consist of and how much capital is returned every year. If you do, you’ll likely just pick a CEF that has a ton of ROC and eventually you’ll be stuck with a big capital loss. It’s never a great strategy to save your long term tax preferred rates for the losses.
There is actually a fund that does this, YieldShare’s YYY and its performance has been pretty horrendous. See for yourself:
The red line is YYY, the blue line is the S&P 500 while the green line is another CEF fund (FOF).
Stock Based Closed-End Funds
I generally prefer bond based CEFs because the funds have a tendency to only pay out income and bonds drift towards par as they get closer to maturity.
Stock CEFs have to rely on capital gains to make up their distributions since the dividend yield on the stocks they hold seldom average more than 2%. During a market draw-down, the stock based funds have a tendency to have their capital permanently impaired since to maintain their distribution, they have to start selling assets with capital losses. Unless they drop their distribution, which funds are loathe to do, the NAV will start spiraling downwards and losing value.
I can illustrate with a very simple example. Ignoring premiums/discounts and compounding, say you have a stock based fund that earns 7% capital gains and 2% dividends (=9%) consistently. Their policy is to be conservative and pay out only 8% per year without leverage, leaving 1% in the fund.
In the 4th year, a pandemic hits and their super stable stocks lose 20% that year, but after that, they return to their 7% yearly gain and 2% dividend. If you look at the table below, once the market drawdown occurs, the share NAV starts spiraling down, leading to a capital loss upon sale of the investment. Less money is available for the rebound because capital is paid out during a down period. On paper, you were still earning your 8% a year on the original investment but once you sell, you’d incur a capital loss which brings your annualized return down from 8% to 4.8%.
Once the capital is impaired on a single drawdown, unless the fund immediately reduces its distribution, it will continue to lose NAV because the distribution becomes oversized relative to it. We’ve had two 20%+ drawdowns in the last two years, so when we get to the screener section later, notice how the vast majority of CEFs have not recovered their NAV as a result.
You will also notice that most stock based funds gradually reduce their dividends every few years as the fund continues to lose NAV and the distribution becomes unsustainable.
Bond and preferred share based CEFs usually just invest in high yield assets and don’t have to sell capital to pay the distribution and there is a better chance of the asset going back to par if they hold to maturity.
What is the Undistributed Net Investment Income (UNII)
By far the most critical factor when choosing a CEF is that the Undistributed Net Investment Income (UNII) is positive. What this number signifies is that their distribution has been less than the income that their assets have been generating. Preferably you will want the fund to have several months worth of distributions in reserve. A negative UNII means they have been paying the distribution from other sources such as ROC or capital gains and the dividend is at risk of a cut.
UNII is a look-back number; in the past they may have generated a large one time NII windfall. The preferable scenario is that the Closed-End Fund is adding to UNII incrementally every month or quarter. UNII will continue to grow each period if the coverage ratio of net investment income to distribution is greater than one. This is a current rate of change number.
If the UNII becomes large enough, the CEF will usually pay a bonus distribution at the end of the year, which juices the yield, responsibly.
Some of the screeners I discuss below provide this information right on the screen itself, but sometimes this information is out-of-date. Other fund families, such as PIMCO, provide a report for all of their funds every month in a nice excel file (I am not endorsing PIMCO with my repeated mentions, but I have invested in several of their funds and I appreciate how they make their UNII report so transparent). I wish every fund family would do it this way.
If your CEF of interest does not provide an up-to-date UNII figure, you’ll need to head to SEC.gov and lookup the semi-annual reports.
Closed-End Fund Selection Criteria
We finally arrive to the pièce de résistance. The following criteria is what you should target to find sustainable, high yield passive income CEFs.
- Coverage ratio of net investment income / distribution > 1
- UNII is positive and preferably has several months worth of distributions in reserve.
- There is no, or minimal, return of capital (if #1 and #2 are met, there shouldn’t be)
- Avoid funds with negative returns on NAV over many years.
- CEF Connect (discussed below), and other tools have NAV plots since inception where you can easily see if its valuation declines every year.
- If a fund’s asset base is consistently declining, it becomes harder to generate the fund’s yield and the current yield will be artificially inflated with pressure to cut it.
- A chart is the easiest way to see this quickly.
- Use the Z-score to determine how relative the discount or premium is to its own history. Extreme values generally revert to the mean.
- Stick to distribution type of ‘Income Only’ and not managed distribution funds that make it a policy to purposely distribute return of capital every year.
- If you are a late stage retiree, you might be okay with a managed policy.
- Generally speaking, stick to bond and muni funds that don’t have to rely on capital gain distributions to meet their yield.
- You can make exceptions if their distribution is responsible or the manager has shown selection skill. Use judgment.
- Stick to broad categories and not niche funds, unless you have some good reason to believe that a niche sector will outperform.
- Know what the underlying holdings are. Each fund provides a semi-annual report that you can access on either SEC.gov or their website. If it is loaded to the gills with a bunch of risky shale drilling type stocks, decide if the yield and discount is worth the risk.
- Don’t choose funds with extreme leverage.
- Remember, too much leverage amps up returns and yields, but also multiplies the effect on the downside.
- As a guideline, it starts to get dicey when a fund is using more than 30% leverage.
- Don’t get too aggressive with yield seeking.
- 7-8% is probably sustainable depending on the fund specifics.
- 12% likely isn’t.
- Make a judgment call if the yield is worth the leverage.
- Levered 40% and only yielding 5%? Might be okay if the underlying assets are safe, low yield munis.
- Check Morningstar.com and look at the risk characteristics.
- What’s its best fit index?
- Does it have positive alpha to that index?
- How does it’s downside and upside capture ratio look like?
- Is the Sharpe ratio higher than the reference index?
- Does it have a termination date coming up with a big fat discount that you’ll be able to capture?
Notice that none of the qualifications is that the fund has a large discount. There are funds worth buying that have a premium, which is usually why they have a premium.
My favorite CEF fund screener, CEF Connect, is run by Nuveen, who are big players in the closed-end fund world.
Another one I like is CEF Analyzer. They have different ways of displaying the data, like heat maps and have direct links to the portfolio holdings held on the SEC website.
Both are free to use.
It’s a little bit of an art to use CEF fund screeners. Sometimes if you set the criteria too strict, you will exclude a fund that you might have otherwise considered. Play around with the settings to get a feel for it and look for the funds that keep coming up in the list for further review.
Again, don’t blindly buy a fund that pops up on a screener, dig in further to make sure it passes the qualifications above.
So for instance, my screener might look like this after selecting CEFs with positive NAV returns, at an above average discount, income only and yields greater than 7%. Consequently, I have owned 4 out of the 10 names that popped up on this list over the last couple of years, but as of this writing I don’t own any of them.
When you run the screener at different times of the year, different funds will pop up based on their relative Z-scores, and how the fund has been doing as of late.
Remember though, screeners don’t guarantee quality from your settings, so don’t treat them as closed end fund recommendations. Case in point is the biggest outlier on the list, OXLC. It has a distribution rate of 32%… gee, you think that is sustainable?
Even though the NAV returns have been positive according to the screener, the fund has been paying out fund capital to meet its massive distribution as shown by its non-total return chart. That fund would require a 32% annual return just for the assets to stay flat after paying outs its distribution. Since inception the fund has lost 66% of its capital, not including distributions, but its total return chart including distributions isn’t so great either.
One final point I should mention that I didn’t address anywhere else is:
How are Closed-End Fund Dividends Taxed?
The tax treatment really depends on the mix of the assets in the portfolio and the CEF’s distribution policy. For most funds, it will be a mix between ordinary income, capital gains and return of capital. You will receive a 1099 at the end of the year and it will have the breakdown.
Overall closed-end funds can be great investments to add to your passive income generating portfolio. The space is awash with bad CEFs though, so you have to be really critical in your selections.
Don’t buy into any closed end fund recommendations that you come across in the web unless you have delved down deeper into its Z-score discount/premium, payout structure, return of capital and what it invests in.
If you find CEFs that have more net investment income than they distribute, don’t lose NAV every year, don’t get too crazy with the leverage, have had a consistent conservative dividend policy since inception, and you use the Z-score to time your buys and sells, you’ll increase your chances of doing well with your selections.
It’s always a smart idea regardless of investment to take a gander at the SEC filings just in case you come across anything suspect. Usually with closed-end funds, the fund manager will write some commentary in the beginning of their semi-annual reports and what they expect for the fund in the future. It can be helpful.
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