As shares of closed-end funds trade on exchanges, portfolio managers don’t need to keep a supply of cash on hand for daily redemptions. That freedom may provide other advantages as well.ipopba/iStockPhoto / Getty Images
COVID-19-related anxiety and global market sell-offs have many investors concerned about their portfolios. That’s particularly true among retirees and those approaching retirement, who make up a large, growing proportion of Canada’s population.
These people rely on income-generation strategies to help sustain them financially. But while the need for income has never been greater, the low interest-rate environment has made yield hard to find. Fixed-income investments don’t produce the reliable yields they did in the past – and that has been exacerbated by the COVID-19 pandemic, which has pushed interest rates even lower.
In fact, the Bank of Canada made three unscheduled cuts to the benchmark interest rate in March; it’s now at 0.25 per cent, down from 1.75 per cent earlier this year.
Investors who are looking to supplement their registered retirement income fund or Canada Pension Plan payments may need to turn to new sources of income.
Closed-end funds (CEFs) are a potential solution to this problem. These funds may offer higher average yields than category peers, including open-end funds (OEFs) such as mutual funds, and exchange-traded funds (ETFs). That’s especially the case during times of market sell-offs.
Units of OEFs are bought and sold at their net asset value (NAV). That’s the total value of a fund’s assets minus its liabilities. In contrast, CEFs’ shares trade on the secondary market, such as the Toronto Stock Exchange.
Why does that matter? Portfolio managers of OEFs must keep cash on hand to meet daily redemptions. That cash doesn’t generate income and can cause a drag on a portfolio’s performance.
But as shares of CEFs trade on exchanges, their prices rise and fall according to investor demand – and their portfolio managers don’t need to keep a supply of cash on hand. That freedom from daily redemptions may provide other advantages, such as allowing investors to purchase CEFs’ shares at a discount to their underlying NAV.
For example, if a CEF is trading at a 10 per cent discount, $100 worth of assets are available for $90. Not only does that provide added exposure to the assets, but it also enhances the effective income yield for each dollar invested in the CEF.
Buying a CEF at a discount provides the potential for another source of return if that discount narrows. But while, a discount also has the potential to widen even more, it’s also possible that the CEF’s shares may trade at a premium. That means shares cost more than the underlying NAV.
The benefits of CEFs for income may become more prominent during market downturns like the one we’re experiencing right now. As volatility has spiked, many investors who hold OEFs have exited the market in a panic. Those funds’ portfolio managers must then raise the cash to meet the redemption requests by selling their holdings. On the other hand, CEFs have a fixed pool of capital, so portfolio managers are able to assess whether they believe it’s an appropriate time to sell the fund’s underlying assets regardless if investors sell their shares of those CEFs.
Another potential advantage of CEFs is the ability to use leverage, which may enhance the fund’s return, income or both. Leverage can enhance a portfolio’s income-generation capacity significantly. It’s a key reason why CEFs have, by and large, been able to produce more income than similar open-end funds over the long term.
However, it’s important to remember that leverage is not a free source of extra returns and does come with certain risks. As markets fall, leverage can amplify those losses. However, there are rules about how much leverage CEFs can employ.
One way financial advisors can incorporate CEFs into their clients’ portfolios is through core-satellite investing. This is a strategy to manage costs, minimize volatility, generate alpha and tailor a portfolio to an individual’s needs. The core of the account is comprised of a passive or beta-like exposure investments, then active strategy positions are added as satellites.
Advisors can implement a core-satellite strategy by combining both passive and active strategies. To do this, they can use investment vehicles like individual securities, separately managed accounts, mutual funds, ETFs and particularly CEFs.
As with all investment decisions, conducting proper due diligence is essential. That’s especially the case today in light of the COVID-19-induced market volatility and general uncertainty. Thus, it’s important for advisors to act prudently on behalf of their clients. But CEFs, as part of a balanced portfolio, may provide an attractive solution for those looking for extra retirement income.
Adam McCabe is head of fixed-income, Asia and Australia, at Aberdeen Standard Investments Inc. and portfolio manager of Aberdeen Asia-Pacific Fund in Singapore.