Income Strategy

Behold The New Diversification Strategy… From The 'Old Person On The Block'

Four good reasons to look closer at closed-end funds

by Steve Selengut

Mr. Selengut is a private investor and a contributing editor to Advisor Magazine. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’

 

The S & P 500 struck 33 new “All Time High” (ATH) levels in 2020, a year that also saw a major market value melt down in March and significant volatility throughout. This year began with ten new highs and more chatter about a serious, extended, correction than I’ve heard over the course of this twelve year Bull Market.

Huge numbers of individual investors, and the vast majority of retirement savings programs, have taken to either Mutual Funds (MFs) or Exchange Traded Funds (ETFs) in an effort to mitigate the ever growing “market value” risk associated with a seemingly upward only stock market.

  • A problem faced by professional managers and experienced investors alike is the perceived scarcity of reasonable yields from all forms of “income purpose”, or correction safe(r) securities. Wall Street has brainwashed investors into believing that their only choices are an upward only stock market or less than 2% “returns” in the bond market… with nothing in between.
  • Additionally, de minimis money market rates have forced trillions of previously risk averse dollars into the stock market (perhaps the reason for the huge upward bias!?), while Wall Street firms seem to be hiding their much safer and higher yielding equity and income alternatives from their customers… yes, they do exist!

ETFs and MFs provide stock market participation with the minimized financial risk of broadly diversified portfolios. ETFs are created by managers but then left to the whim of investors; MFs become unmanaged quickly, as soon as the shareholder “mob” takes over in times of excessive greed or panic. Neither type has a fixed number of shares, so various types of share and unit manipulations are needed to have them trade at their “Net Asset Value” (NAV).

Clearly, if safety of principal is among your investment concerns, investing in a diversified portfolio of securities is exponentially “safer” than trying to pick “winners” in the form of individual stocks. But there is a better, higher yielding, actually managed portfolio way to take advantage of lower risk, diversified portfolios… and at a significant discount to NAV.

Closed End Funds

Closed End Funds (CEFs), (which have a history 20 years longer than MFs and more than 100 years longer than ETFs) are an “old person on the block” that provides investors/traders with four tangible benefits over and above the diversification benefit of the other two, and the daily trading capability of ETFs:

1. CEFs are actively managed, diversified, portfolios of all shapes, sizes, and emphases; a fixed number of shares are sold to the public in a traditional IPO (initial public offering)

Similar to regular common stock, CEFs are ownership shares of an investment company whose business is the management of a particular portfolio of securities. The management goal is to produce income (in several forms) for shareholders… not to grow the value of their stock holdings. Their fundamental design requires that they disburse more than 90% of their realized income… thus growing actual capital for shareholders regardless of market value direction.

I use 205 different CEFs in my managed portfolios, roughly half the total population you can research at several different websites (Google CEF Research Websites). I avoid any that are less than 5 years old or which hold fewer than 50 individual securities, and I don’t look at “income purpose” funds with distribution rates less than 6.0%. There are more than 40 different categories of CEFs, domestic and global, equity and income, to diversify among… similar to ETFs and Mutual Funds.

A problem faced by professional managers and experienced investors alike is the perceived scarcity of reasonable yields from all forms of "income purpose", or correction safe(r) securities...

Yes, there are also CEFs that focus on and/or include some public REITs (Real Estate Investment Trusts) and MLPs (Master Limited Partnerships).

  • Unlike Mutuals, CEFs trade throughout the day; unlike ETFs most CEFs (nearly 80%) trade at prices below the NAV of the fund assets; unlike either of the others, CEFs actually have managers who will sell when profit targets are reached and add to positions (or buy new ones) when prices fall.

2. Closed End Funds trade throughout the day at prices around 10% below NAV

On average, Equity Closed End Funds contain 200 individual company stocks, including many NASDAQ “hotties”, Big Board “blue chips”, and dividend “aristocrats”. The average distribution yield on the 85 I follow is over 8%… in your pocket spending/reinvestment money.

  • At the February 8th stock market ATH, 78% of the equity based CEFs were trading at discounts averaging nearly 10%… 34 were at discounts above 10% while only 13 were below 5%.
  • Only 18 were trading at prices above the NAV, and for all but three of those, the average premium was just 5%.

So yes, you are effectively buying your favorite stock market companies at a nice discount… something you just can’t do with any other form of security.

3. CEFs are “pass through” securities that must pay out 90% of dividends, interest and other earnings (98% of realized capital gains), to maintain their tax exempt status

Unlike ETFs and Mutual Funds, Closed End Funds are required to distribute most of their earnings and realized capital gains each year. They are not forced to take profits but most seem more interested in producing income for their shareholders than chasing higher NAVs (as is the case with ETFs and MFs).

Managements use non margin borrowing, covered call writing, and preferred share issues to enhance their income production. Any pass through dollars other than interest, dividends and capital gains are tax free distributions (called Return of Capital) which are automatically applied to reducing the cost basis of the shares you own.

4. Most CEFs pay monthly distributions about twice the size of those provided by the vast majority of ETFs, MFs, and Dividend Stocks

  • The average distribution rate for the 85 equity CEFs I work with is 8.2%; only 2 pay less than 5% and 19 pay 9% or more. 70% of them pay monthly distributions.
  • The average distribution rate for the 117 income focus CEFs is 8.3%; only 1 pays less than 6% (5.96); 58 pay 8% or more. 97% pay monthly.
  • Note that CEFs holding Master Limited Partnerships (MLPs) DO NOT send K-1 forms to shareholders, and that many use “tax managed” profit taking protocols.

The case for CEFs is a strong one and much more can be learned by joining the totally free Facebook Closed End Fund Education and Discussion Groups.

In your research and in conversation with “Wall Street” pros, you will come up against two criticisms of CEFs that you should not allow to deter you from further investigation: “leverage” and ROC”. Leverage is simply the non-margin borrowing used by all corporations (and most individuals)… short term borrowing at say 1% to purchase securities with longer term payouts of 3%.

Return of Capital could be from several sources, but the only thing that can make it “destructive” (since it reduces cost basis dollar for dollar) is if you spend it. Think of it like you would the principal on a mortgage you hold or the bulk of an annuity payment…. if you spend it, you’re spending a return of capital. If you reinvest it, nothing has been “destroyed”.

The two articles, and two numbers, provided below should help clarify these issues and help to move you in a more profitable and higher income direction… with a significant discount on most of your stock portfolio purchases.

  • The numbers: In 2020, the nearly 300 CEF portfolios I follow generated realized income on invested capital of just over 9% with just under $8,000,000 of in-the-pocket income. Roughly $2.2 million has already been generated in 2021.