A Treatise On Closed End Funds

From A Market Risk Vantage Point, All Securities Are Created Equal

From a financial risk point of view… not so much

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.’ He can be reached at sanserve@aol.com.

All investing involves risk. All marketable/tradable securities are subject to both “Market Risk” and “Financial Risk, among several others. Market Risk is actually the very nature of all securities, as all are constantly changing in market value for a myriad of reasons. But changing market values do nothing to alter the intrinsic nature of a security, its income production, or the viability of its issuer. Just a basic fact of investment life.

Financial Risk is a much more complex animal… it goes to the actual viability of the entities that bring investment securities public: corporations, governments, financial institutions, etc. This is the risk of default, killer lawsuits, government regulation, and bankruptcies that make securities totally or partially worthless (Like Merrill Lynch and Lehman Brothers during the financial crisis, and Enron several years earlier).

“Investments 101” taught us that debt based securities are always financially safer than equity/ownership securities. Only US Government bonds are (possibly) free of financial risk.

Individual Securities vs. Funds

Nearly one hundred and thirty years ago (in 1893), some financial genius determined that a combined portfolio of individual securities (all varieties) would greatly mitigate financial risk, while creating other distribution benefits. If any one entity defaulted or went under, there would be hundreds of others to lessen the blow… Most of you are thinking: “ah, the dawn of the Mutual Fund”. Nope, Closed End Funds were the first “funds” on the investment landscape, created in Europe pre 1850! Mutual Funds arrived on the American scene about 30 years later. The first index fund hit the markets in 1971; the first ETF in 1990.

The original fund idea (professionally managed portfolios of securities that investors could use to reduce financial risk) was, perhaps, the most important investment innovation ever. It provided cheaper, less risky, entry into the securities markets, bringing “investing” possibilities to the masses, and opening the door for employee benefit programs.

But only the (original) Closed End Fund varietal emphasized income production in its design equation. This remains the case today.

In spite of these brilliant financial risk minimizing innovations all forms of Wall Street performance measuring tools focus solely on the mostly temporary and harmless changes in the market value of investor portfolios… regardless of their cumulative financial risk! This Market Value “tunnel vision” totally ignores both the realities of the market cycle, and the critical importance of income.

Apples, Oranges… and CEFs

Funds and ETFs are less financially risky than any securities they contain. And, a portfolio of funds, no matter how poorly diversified, is less financially risky than portfolios of individual securities no matter how well diversified...

The general investor population seems totally oblivious to the financial risk within their individual security portfolios. The market averages measure only market value, the financial icon Wall Street commands us to worship, no matter what our risk tolerance or income needs.

From a market risk vantage point, all securities are created equal. From a financial risk point of view they clearly are not. Stocks are more risky than bonds; income securities less risky than equities; governments less risky than corporates; futures, options, commodities, illiquid products, etc. most risky of all.

Funds and ETFs are less financially risky than any securities they contain. And, a portfolio of funds, no matter how poorly diversified, is less financially risky than portfolios of individual securities no matter how well diversified. Also, in dealing with income purpose securities, funds are the only mechanism that provides instant liquidity and the ability to actually take advantage of both higher interest rates and lower market values. That said, and with the knowledge that the best individual securities are likely to be inside funds and ETFs, investors need only decide which of the three they should focus on.

There are over 300 managed CEFs (that meet the strict quality, diversification, and income production standards of this author). There are 3,000 unmanaged ETFs and 7,000 “mob managed” Mutual Funds to choose from.

Mutual Funds, Index ETFs, and regular ETFs are unmanaged programs with low fees and manipulated market prices, typically paying very stingy dividends, and with prices that are manipulated to be equal to Net Asset Value. Individual stock and bond prices are rarely equal to net asset or par value, respectively, making CEFs much more in line with market realities.

ETFs admit to passive management while Mutual Fund “part time” managers must sell or buy based on the mood of their shareholders. CEFs, on the other hand, are actively managed and have no fixed relationship with NAV (just like their security content).

The average CEF pays from two to three times more in distributions (most often monthly) than most of the others and have been doing so longer. Read that again!

Practically all income CEFs, and most stock based CEFs are designed and managed to maximize the income paid to their shareholders. The others are designed to grow the market value of their shares for the illusory benefit of shareholders and fund sponsors.

No Contest

So investors, particularly those planning for retirement, do you want the 3% or less paid by most ETFs and Mutual Funds or the average around 9% now being paid (after expenses) by roughly 300 Equity and Income Closed End Funds? And then there’s the thirty or more Tax Free CEFs paying distributions averaging over 6.0%…

Is there really any contest here?