Closed-end funds could be an possibility for retirees searching for portfolio revenue
If you are trying to get portfolio income off-market, closed-end funds can be part of a solution.
With near-zero returns at US Treasuries, the once-common strategy of retirees to safely generate income at a rate that outperforms inflation is not working as well. That said, many retired investors still want to keep some cash out of the volatility in the stock markets so they won’t be able to sell on the dips or during a bear market when they need cash for their living expenses.
“It’s a battle out there,” said Ken Nuttall, a certified financial planner, chief investment officer for Black Diamond Wealth Management in New York. “We have customers in their retirement years looking for income.”
Closed-end funds, which have been around since the late 19th century, are more risky than Treasuries, but can also generate reasonable returns that may have a place in the earnings section of your investment portfolio.
At the end of 2019, 500 closed-end funds had total assets of USD 278 billion, according to the Investment Company Institute. That’s the equivalent of a $ 21.3 trillion mutual fund.
However, unlike traditional mutual funds, closed-end funds generally issue a certain number of shares when they are set up – much like a company that goes public – and act like a stock in the open market. This means that while the share price may be related to the performance of the Fund’s underlying assets, it is based on investor supply and demand.
This means that closed-end fund units can routinely trade at a discount or below their so-called net asset value (the final result of the fund’s assets divided by the number of units outstanding). Or they can trade at a premium (above the net asset value).
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Much of the appeal of a closed-end fund comes from the fact that stocks can be bought at a discount when the opportunity for growth exists. For example, if a particular stock sector has been hit by sentiment, a closed-end fund investing in that sector may trade at a price below its net asset value, making it a cheap way to get into that segment of the investment world.
Like many traditional mutual funds, they are actively managed – which means experts choose the underlying investments, whether stocks, bonds, or other investments. And many generate income that is distributed monthly or quarterly. Most of the assets (61%) in closed-end funds are invested in bonds, according to the Investment Company Institute.
These funds can also invest their assets in less liquid assets such as very small businesses, under-traded municipal bonds, or emerging market securities.
“One thing we like is that you can get esoteric assets that you couldn’t get in a mutual fund,” said Nuttall.
Many closed-end funds use levers that are subject to regulatory restrictions to increase their returns. That is, they can borrow money to invest. However, leverage also means that losses can also be exacerbated.
“We take that into account,” said CFP Robert Finley. “When you see [an investment] This is really down, we’re more open to leverage.
“However, in typical times, we avoid leverage as it offers more downside protection,” said Finley, principal at Virtue Asset Management in Chicago.
What it will cost you
When it comes to cost, there is a wide choice.
“If you look at a leveraged closed-end fund, the expense ratio could be over 2%,” said Finley. “However, some of the Muni-Bond funds we use are 0.3% or 0.4%. They differ depending on the sector and asset allocation.”
In general, you will be required to pay tax on any income or capital gains distributed to you as a closed-end unit holder. When you sell shares in the Fund, you can earn either a taxable profit or a taxable loss, depending on the purchase price.
And towards the end of the year, when investors experience tax losses – selling investments at a loss to offset gains elsewhere – chances are some closed-end funds may trade at lower discounts.
“Closed-end funds tend to be sold depending on how the year has gone,” said Nuttall. “This tends to increase the discounts.”
However, at the beginning of next year, that discount will tend to decrease, he said.
While this depends on the client and the specific situation, it may be worth limiting your closed-end fund investment to 5% of your income portfolio, Finley said.
The returns achieved depend on the fund.
“A Muni bond closed-end fund can be 3%, but one in master limited partnerships can be in the mid-single digits or higher,” said Finley. “It depends on which asset class you buy.”
And as with any investment, do your research on the fund and its managers’ track record.
“At the end of the day, you need to know what you have,” said Nuttall.