Confronting volatility with closed-end funds
There’s no shortage of news headlines to make investors anxious before they’ve even finished their morning coffee. Chief among them today is coronavirus (COVID-19), which has sent markets into a tailspin. In these times of market volatility, we believe that closed-end funds (CEFs) may provide a compelling opportunity for investors.
Investors and markets had a muted reaction to coronavirus at first, when the virus appeared to be restricted to mainland China. Since early 2020, however, the number of cases has ballooned worldwide.
At the time of writing, coronavirus has infected more than 100,000 people worldwide, and coronavirus fear has infected the minds of many more. Investors and markets have begun to react negatively. The last week of February was the worst for global equity markets since the peak of the global financial crisis (GFC) in 2008. In the first week of March, the CBOE Volatility Index (VIX), which reflects market uncertainty and fear, hit its highest level in nine years amid global anxiety.
In a frenzy of coronavirus-driven fear, U.S. investors pulled $11.86 billion from long-term open-end mutual funds and ETFs in the week leading up to February 2, according to the Investment Company Institute.
CEFs may offer an advantage during market sell-offs such as this. When open-end funds experience a sell-off, their managers must sell assets quickly in order to raise cash to meet redemptions. CEFs, on the other hand, operate on a fixed pool of capital. Trades in the secondary market fulfill redemptions; that is, the managers are not required to raise any cash from the portfolio.
It’s important to note that CEF investors are still able to redeem their holdings, as they would with a listed operating company like Amazon or Alphabet. The difference is that CEF managers are able to look through marketplace short-term noise and potentially take advantage volatile markets. A CEF manager can consider whether or not it’s an appropriate time to sell assets, independent of any investor redemptions.
CEFs also offer access to defensive asset classes. There are plenty of CEFs investing in defensive areas with low correlations to equities, such as infrastructure.
CEFs also offer access to defensive asset classes. There are plenty of CEFs investing in defensive areas with low correlations to equities, such as infrastructure. Private assets can also dampen NAV volatility. Private assets can be attractive diversifiers when markets fall rapidly because they are not marked to market on a daily basis. Therefore fundamentals — not sentiment — drive their valuation.
CEFs may also provide an attractive source of income in volatile markets. In response to the escalating concerns about coronavirus, the U.S. Federal Reserve (Fed) announced an unscheduled, emergency benchmark interest-rate cut on March 3 — the first of its kind since early days of the GFC. The current federal funds rate is now in a range of 1% to 1.25%. Additionally, the 10-year U.S. Treasury yield has fallen to a historic low of below 1%. These factors both put pressure on investors looking to generate income. Many CEFs continue to pay attractive income yields, and therefore may be worth consideration.
CEF shares are bought and sold on the secondary market, so supply and demand drive their prices. These shares may trade above their net asset value (at a premium) or below (at a discount). Share prices of many CEFs fell alongside equity markets in the last week of February, which we feel presents a buying opportunity to investors.
CEF share prices haven’t been immune to the recent market sell-off. According to Morningstar, the average CEF was trading at a discount of 2.37% on Monday, February 24. By the end of the week, the average discount widened to 6.12%. CEF discounts can narrow significantly in relatively short periods of time. Buying a fund at a historically wide discount provides another source of return for investors if the discount moves closer to its historic average. Investors must bear in mind, however, that discounts are not guaranteed — buying at a premium is also a possibility.
Chart 1: Average discount/premium in CEFs from 2008 to today
Source: Morningstar, ASI, March 5, 2020
However, investors should not focus on discount alone. Fundamentals, including investment manager philosophy and track record, along with the outlook for the underlying asset classes, should come first. And, above all, investors must consider how a fund fits in with their broader portfolios.
CEFs – and, more broadly, active management – may present a compelling opportunity for investors seeking to weather the coronavirus storm. Unlike passive funds, active managers have the flexibility to react thoughtfully to supply-chain disruptions and market shocks such as this. Active managers are able to follow an investment process that buys high-quality companies with strong balance sheets and an ability to cover their dividends. Passive investments, on the other hand, are bound by the indices they track. Before making any decisions, investors must consider their individual investment needs, but we believe that CEFs may be an attractive opportunity when confronting market volatility.
Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund’s investment return and principal value will fluctuate so that an investor’s shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund’s portfolio. There is no assurance that the Fund will achieve its investment objective. Past performance does not guarantee future results.
The use of leverage will also increase market exposure and magnify risk.
Closed-end funds are similar to mutual funds and exchange-traded funds (ETFs) in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds and ETFs, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Open-end funds can be bought or sold at the end of each trading day at their net asset values (NAVs). Because closed-end funds and ETFs trade throughout the day on an exchange, the supply and demand for the shares determine their market price; closed-end funds’ and ETFs’ market prices may fluctuate through the trading day and those prices may be higher or lower than their NAVs. Closed-end funds, mutual funds and ETFs charge investors annual fees and expenses. All of these products may use leverage to enhance their returns, which can magnify a fund’s gains as well as its losses. Closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. All three vehicles seek to deliver returns based on their investment objectives, but none of them are FDIC insured. The Revenue Act of 1936 established guidelines for the taxation of funds, while the Investment Company Act of 1940 governs their structure. Aberdeen Standard Investments does not provide tax or legal advice; please consult your tax and/or legal advisor.
In the United States, Aberdeen Standard Investments is the marketing name for the following affiliated, registered investment advisers: Aberdeen Standard Investments Inc., Aberdeen Asset Managers Ltd., Aberdeen Standard Investments Australia Ltd., Aberdeen Standard Investments (Asia) Ltd., Aberdeen Capital Management LLC, Aberdeen Standard Investments ETFs Advisors LLC and Standard Life Investments (Corporate Funds) Ltd.