Closed-end funds, income and Pandora’s box

The investment world isn’t what it used to be, and that has implications for those seeking income. Returns in the past 20 years are unlikely to be sustained over the next 20, according to a recent study by McKinsey Global Institute.1

The years stretching between 1985 and 2014 were representative of a “golden era” for investors, but the road to income, earnings and retirement could look substantially different in the future. McKinsey experts predicted a 200 basis point (bps) difference in average returns, which translates to today’s average 30-year-old having to work seven years longer or double the savings rate in order to match what would have previously been achieved. Pensions, endowments, governments and other institutions will also have to ready themselves for a new kind of environment.

In recent years, market trends were able to buffer some of the diminishing returns, but those trends now appear to be slowing down. Global gross domestic product (GDP) growth can still grow but may be sluggish. The business landscape is also changing, as both developed and emerging markets face individual woes and vie for a top spot in an increasingly competitive environment.

Despite the uncertainty and the relatively feeble forecast, there is a lesson to be learned here. Even Pandora’s box came with hope. Instead of focusing on what investors won’t be getting in the future, it may be more helpful for investors to learn to readjust their strategies and expectations.

Investors can start to look for income in less traditional paths, which may require them to go outside their usual comfort zone.

One example of a less traditional path is closed-end funds (CEFs). Less well-known than both mutual (open-end) funds and exchange-traded funds (ETF), CEFs fall somewhere in the middle of the spectrum.

Many CEFs were built to provide income paying out monthly or quarterly dividends that generate attractive income streams. If investors choose not to receive these dividend payments in cash, they can have the dividends re-invested in the fund, which may enhance total long-term returns.

Unlike open-end funds, CEFs trade on exchanges like stocks, and unlike many ETFs, CEFs are often actively managed. A CEF raises a fixed amount of capital at inception through an initial public offering (IPO), and the shares of the fund are subsequently traded on an exchange just like an investor would do with a stock. Because of this, CEFs are continuously priced throughout the day by the market.

CEFs tend to be efficiently managed because the number of shares outstanding are fixed after the IPO. Managers can stay fully invested at all times and don’t have to worry about cash redemptions during times of market stress. This helps avoid the forced selling that can affect the value of an asset pool. In the long run, the structure of CEFs can promote consistency, which can be attractive for investors who choose to stick it out for the long haul.

This kind of stability is useful for another reason. A CEF’s capital structure can be particularly handy when investing in niche and less-liquid markets or employing strategies that would otherwise be harder for other types of investment vehicles to manage. This can range from investing in specific regions to a group of countries or specialty assets and strategies such as real estate investment trusts (REITs) and hedging techniques.

All of these attributes can be effective in the search for income and capital appreciation, especially in an environment where expectations can’t be as far-reaching as they once were. Income and income diversification remain the top reasons an investor chooses to buy into CEFs, with two-thirds of CEF users viewing CEFs as a long-term asset, according to a 2016 survey of advisors by Nuveen.

That is likely the reason the CEF user-base continues to grow, with investment in CEFs having increased 29% on a percentage basis from 2013 to 2016, according to the same Nuveen study. Among CEF users, 70% and 78% believe CEF assets offer very attractive yields and can help increase cash flow to a portfolio when used appropriately, respectively. These investors appear to be pretty satisfied despite what concerns they may have about the global markets, politics or the future. In other words, they seem to be hopeful.

What does this mean for other investors? Whether or not an investor chooses to go down the CEF path, this shows that income potential can still be reached in spite of a new and shifting market environment. It just may not come from the same sources that investors had once been able to depend on. It may require investors to cast a wider net and land on, or catch something, that may be different from what they were originally used to but can turn out to meet (or maybe even exceed) their expectations. Here’s hoping.

1 “Diminishing Returns: Why Investors May Need to Lower Their Expectations,” May 2016, McKinsey Global Institute in collaboration with McKinsey’s Strategy and Corporate Finance Practice.

Important Information

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The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.