Morningstar hosted its annual investment conference in Chicago earlier this month. Not surprisingly, one of the biggest themes of the three-day event was income generation. The million-dollar question is how investors can position their portfolios in order to earn enough income or to generate enough capital appreciation to overcome the detrimental effects of inflation? After listening to a number of discussions about low interest rates and expectations of inflation, I found myself wondering why closed-end funds still remain the often ignored stepsister of the much lauded open-end mutual fund. Given their many unique benefits and the aneamic outlook for traditional income-oriented investments, investors should be flocking to CEFs.
I'll back up a bit and provide some context for my musings. The conference was kicked off with an address from PIMCO's Bill Gross who presented a rather morose picture for the future of the United States and for fixed-income investors. His anti-Treasury stance has been well documented and well criticised over the past few months as interest rates have remained at historically low levels. He opined on negative real interest rates provided by five-year Treasuries and told the crowd that the U.S. government was "picking the pockets" of savers by keeping rates artificially low. The cherry to top his gloom-and-doom sundae was his proclamation that, 15 years from now, investors sticking with U.S. Treasuries will have experienced "financial repression" due to negative real interest rates. His proposed solution? Invest in blue-chip, dividend-paying stocks and the sovereign debt of nations like Canada, Brazil, and Germany.
Not surprisingly, the bond guru touting equities and predicting a veritable lost decade created a lot of buzz with the media and attendees at the conference. For me, the biggest takeaway from his speech was not that the sky was falling, but that despite low interest rates and economic uncertainty, investors have options. Whether you agree with Gross or have a more positive view on the future of the U.S. economy, almost everyone can agree that with short-term interest rates near zero, investors are in need of securities that provide a healthy total return, be it from capital gains, dividends, interest income, or a combination of the three. CEFs are great vehicles for income-generation and capital appreciation as well to gain access to the many markets Gross believes will outperform U.S. Treasuries. For investors who have long ignored CEFs, now may be the time to dip your toe into the water.
Because the funds are closed, managers do not have to deal with the inflows and outflows of cash based on investor whims and market sentiment. This allows funds to stick to their strategies even during rough patches like 2008 and cuts down on the performance lag that often accompanies open-end funds that have become bloated due to intense investor interest. It also allows CEFs to hold illiquid securities, offering investors access to niche areas of the market that may be otherwise out of reach. And, funds are able to use leverage which, when used properly, can pack a powerful punch increasing distributions and total returns (of course, leverage can work against a fund during market declines, compounding its losses). You can learn more about the basics of CEFs in our Solutions Centre.
The CEF universe of more than 600 funds available to UK investors offers something for everyone including Bill Gross-approved blue-chip equities, developed- and emerging-markets debt, and global equities. The ability to buy CEFs at a discount to net asset value should appeal to value investors. (The average CEF discount sits at just under 11% today.) Investors can use relative discounts and premiums as well as z-scores to seek out and snap up funds trading at discounts or premiums to their historical averages, increasing return potential.
In fact, I have often marvelled at my own ignorance of CEFs before I began to analyse them more closely. Where was the investor education and information surrounding these nuanced funds? How is the average investor to know they even exist? Imagine my surprise when a conference attendee told me that he could not understand why Morningstar decided to cover CEFs now. In his mind, we ignored the space for such a long time only to jump in when the market was heating up. He said Morningstar tells investors the worst investment mistake is to buy at the top and sell at the bottom. Is that what we are doing with CEFs?
It's an interesting observation, but it misses the point. CEFs are not the latest "hot commodity." While we've seen an uptick in IPOs over the last year, CEFs are still dismissed by far too many investors. When we first announced our foray back into coverage of CEFs, my colleague Mike Taggart proclaimed that "our aim is to shed light, a high-powered spotlight, on closed-end funds." Over the past year, we have been doing just that. With the economy recovering in fits and starts and developed world central banks seemingly reluctant to raise interest rates, investors are looking high and low for income-generating investments. CEFs are poised to make a comeback.
Click here to visit our Closed-end Fund Centre.
