Closed-end funds, commonly referred to as CEFs, are popular investments for income-focused investors, especially retirees. There are numerous good reasons for this, which we will go over in this article. However, it is important for investors to be particularly cautious about investing in the closed-end fund space in the current environment. In this article, we will discuss why.
Advantages of Investing In Closed-End Funds
First, CEFs are well-diversified, typically holding scores if not hundreds of individual positions, reducing the risks incurred by any single company in their portfolio. Second, they’re often actively managed, which means they can adapt their holdings and strategy to changes in macroeconomic conditions, as opposed to being bound to a passively managed algorithm.
Third, they trade just like a stock and are therefore not completely tied to their underlying net asset value, in contrast to ETFs, which always trade at a very tight spread relative to their net asset value. As a result, investors can often buy CEFs at a meaningful discount to the value of their underlying portfolio, thereby effectively buying stock at a discount.
Another major advantage of CEFs for income-focused investors is that they often pay out very high distribution yields, including in many cases on a monthly basis. This is much less common with ETFs, which tend to pay out lower yields and only on a quarterly basis. Though some funds like the JPMorgan Equity Premium Income ETF (JEPI) and JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) have changed that by paying out high yields and being well-diversified.
However, the difference between ETFs like JEPI and CEFs is that JEPI generates this high yield from employing a notional covered call strategy, where the premiums from its notional covered calls fund the distribution, thereby capping upside during a bull market. In contrast, CEFs often support their high yields by employing leverage in their portfolios and investing that borrowed money into higher-yielding securities. The spread between the higher-yielding securities and the margin interest they pay enables them to enhance their yields. Additionally, some CEFs even pay out beyond what they generate from internal dividends by liquidating some of their capital gains over time.
Regardless, between the leverage and enhanced yields, these CEFs can be powerful income generators and also potentially provide outsized total returns during a rising market. Many investors further reduce the risk posed by elevated payouts and relatively high leverage by diversifying across numerous CEFs, thinking that if one or two of their funds were to cut their dividends, the diversified nature of their CEF portfolio would help smooth out the volatility to their income and their underlying principal.
Why CEFs Are Risky Investments Right Now
That being said, CEFs also come with heightened risk right now. First and foremost, the leveraged nature of CEFs makes them quite risky. In addition to the high cost of leverage in the current elevated interest rate environment, the use of margin leverage also dramatically increases the risk to the long-term compounding process. As Warren Buffett once warned:
there are only three ways that a smart person can go broke: liquor, ladies, and leverage.
Moreover, he warned that:
you really don’t need leverage in this world much; if you’re smart, you’re going to make a lot of money without borrowing.
The reason why leverage, especially margin leverage, is so dangerous is because, as Warren Buffett once again shared with Berkshire Hathaway (BRK.A, BRK.B) shareholders in a 2019 shareholder letter:
when it comes to margin debt, even if your borrowings are small and your positions aren’t immediately threatened by a plunging market, your mind may well become rattled by scary headlines and breathless commentary, and an unsettled mind will not make good decisions.
Moreover, anything can happen at any time when investing. As he also stated in that same letter:
there is simply no telling how far stocks can fall in a short period. Over the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. But at any time, the light can go from green to red without pausing at yellow.
In fact, Berkshire Hathaway has seen its stock plunge five times in its history. Between 1973 and 1975, Berkshire’s stock crashed by 59%. In 1987, it plunged 37%. Between 1998 and 2000, it dropped 49%. Between 2008 and 2009, it dropped a whopping 51%, and in the 2020 COVID crash, it dropped 26%. Suppose Berkshire shareholders had used significant margin leverage during any of those crashes. In that case, they may have faced margin calls, and the long-term powerful compounding machine that Berkshire has been for many decades could have possibly been interrupted as they may have had to sell some or even all of their shares to cover those margin calls, locking in those losses permanently and then missing out on at least some, if not all, of the subsequent upside.
It is for this very reason that CEFs are highly risky. In fact, we learned this the hard way during the 2020 market crash. We were heavily invested in the now-defunct Nuveen Energy MLP Total Return CEF because it traded at a steep discount to NAV and offered leveraged exposure to some of the leading and strongest MLPs like Enterprise Products Partners (EPD), Energy Transfer (ET), and MPLX (MPLX). However, given that it had a 30% leverage ratio at the time, which unsurprisingly significantly juiced its dividend yield, it was very susceptible to the massive crash that rattled the energy sector during the COVID outbreak. As a result, the fund actually had to shut down and liquidate itself due to its margin debt, and investors were left with heavy losses.
Keep in mind that this can happen anytime to any leveraged fund due to a Black Swan event or even perhaps not such a shocking event taking place. If you look at the current environment in which we find ourselves, there are numerous risks that seem quite elevated and could inflict mayhem on the markets should they come to fruition. For example, recent economic data increasingly points to the probability of an economic slowdown in the near future. Manufacturing activity contracted for the second straight month, and the Atlanta Fed’s GDPNow model recently reduced its growth forecast for the second quarter from 2.7% to a strikingly low 1.8% due to weak data from the Institute for Supply Management and the Census Bureau. Unemployment continues to edge higher and is close to 4%.
Meanwhile, consumer spending is also declining, with disposable personal income dropping by 0.1% in April for the second time in three months. Plus, the personal savings rate has declined to 3.6%, the lowest it has been since December 2022, and the consumer savings that had built up during COVID has now been completely spent.
On top of that, geopolitical risks are also skyrocketing, with rhetoric growing increasingly hostile between China and its neighbors, particularly Taiwan and the United States. Fears of the Russian-Ukrainian war continuing and potentially expanding to other portions of Europe, and the war in the Middle East continuing to rage on and also at risk of potentially expanding. Additionally, oil stocks are increasing around the world, with OPEC announcing oil production increases moving forward, and copper stocks swelling on the Shanghai Exchange, indicating slowness in the Chinese economy, which is the largest consumer and buyer of copper in the world. And of course, the yield curve remains sharply inverted, which is also an indicator of a recession.
Finally, monetary policy also looks like it will remain a headwind, with the Fed having to balance its war against persistent inflation with trying not to keep interest rates too high. However, the Fed has erred on the side of keeping rates higher for longer, which is a threat to stock valuations as well as underlying business fundamentals. Meanwhile, the bond market continues to bet on a recession, with the yield curve remaining inverted and 10-year Treasury rates falling.
Finally, the stock market remains significantly overvalued based on numerous leading indicators. This means that if geopolitical and/or macroeconomic risks materialize into actual headwinds, the market could see a significant pullback or even a crash. As a result, CEFs with their significant amount of leverage are particularly risky in the current environment. For example, the investor-favorite PIMCO Dynamic Income Fund (PDI) is quite risky in our view because it trades at a large premium to its net asset value, is heavily leveraged, has a high expense ratio, and invests in lower-quality loans.
As a result, if the market crashes and the economy with it, PDI will likely not only see its net asset value and therefore its stock price plunge, but its stock price will plunge even more due to its significant premium to NAV at the moment. Additionally, its dividend will likely get slashed as its underlying assets experience a growing number of defaults.
Moreover, other CEFs that we actually like a good bit more, such as Cohen & Steers Quality Income Realty Fund (RQI), Cohen & Steers Infrastructure Fund (UTF), and the Reaves Utility Income Trust (UTG), will all likely also suffer as none of them have much in the way of margin of safety in their price to NAV at the moment. They all have a meaningful amount of leverage and do not have much, if any, full coverage of their underlying dividends from internally generated cash flows. As a result, if another market crash should occur, especially if a sharp economic downturn is the catalyst for it, we would not be surprised if all of these CEFs saw large price draw-downs and potentially even some dividend cuts.
Investor Takeaway
While CEFs are powerful passive income tools that can make retiring from passive income more simplified for retirees, they are still risky investments, particularly due to their heavy leverage in the current environment. It is quite possible that any one of a number of potential catalysts could materialize to send the economy and the market down sharply. CEFs could get hit quite hard as a result. Retirees who depend on them for passive income should potentially diversify their holdings into other positions that are more likely to sustain their payouts through such a scenario.
One excellent and simple option for those who do not need such high yields is the Schwab U.S. Dividend Equity ETF (SCHD). However, for those who want higher yields, we are building a diversified portfolio of high-quality, high-yielding individual stocks. One of our favorite picks currently is Enterprise Products Partners (EPD), as it is very likely to be able to sustain its distribution through downturns. For those who do not like the K-1, however, we think that Enbridge (ENB) is one of many suitable alternatives.
Read the full article here