Fees in closed end funds not only include the basic management fees and fund expenses as you would see with ETFs, but also the cost of any leverage used, so this additional component must be included in assessing the total cost of the CEF.
Many tout the ability for closed in funds to invest in illiquid securities as a benefit. By the Investment Company Act of 1940, open-end funds and ETFs are limited to 15% of the portfolio in “illiquid” securities, while closed-end funds do not face that same restriction and are able to invest a larger portion of the portfolio in illiquid securities. While some investors may see this as a positive, we doubt all investors will. Even if a CEF is not forced to sell securities to deal with redemptions, their holdings are still priced on a daily basis and the fund NAV is reported on a regular basis, so if there is a market downturn having an outsized impact on the security pricing of this higher portion of illiquid securities that would be reflected in fund NAV.
Return of Capital
Some closed end funds have managed distributions/dividends as a fixed percentage of assets, and if there is not enough income generated during the period, then the fund can make up the capital shortfall with a “return of capital” included in the distribution. While this return of capital is not taxable and instead lowers the cost basis for the investor, a return of capital would reduce the fund’s net asset value and future earnings power. ETFs do not have fixed distribution rates, thus payout income generated and don’t face the return of capital issue.
We view active management as the best option for investing within the high yield market and traditional open-end mutual funds, closed end funds, and ETFs all offer investors a way of accessing actively managed high yield portfolios. However, each investment vehicle differs in terms of its structure, and investors need to understand the dynamics behind each structure. And as with all fund investing, we caution investors to review the underlying holdings of the portfolio. For instance, does a “high yield debt” portfolio include other assets, such as emerging market, government, or investment grade debt?
We see wise investors as those that take the time to understand what the own, be it the dynamics of the investment vehicle or the securities within it. Most relevant in looking at ETFs versus CEFs, investors must understand the positives, negatives, and additional risks that can come with outsized discounts and the use of leverage for high yield funds. For the high yield market, we view an active, unlevered ETF as a more straight-forward way to access the asset class. With the additional fund transparency, potentially more tax efficiency and simplified distributions, and much narrower discounts to NAV (thus not relying on the additional element of the market narrowing or keeping stable the discount), we would favor ETFs. Additionally, if an investor would like to lever up the assets, they can do that on their own rather than being forced to at the manager’s discretion within the portfolio.
1 Taggart, Mike, CFA, “CEF Market Overview,” Second Quarter 2015, Nuveen Investments, Inc., p. 1-2.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. Information on this website is for informational purposes only. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risk and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
This article was written by Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD).