Financial Professionals

Market Insights

A A A

Remaining Agile: Closed-End Funds Prepare for the Future

05/14/2013

A key advantage of closed-end funds over open-end mutual funds is that portfolio managers are free to trade underlying holdings when they see fit. Their “closed” capitalization enables these funds to avoid certain challenges open-end fund managers face: net inflows when a fund’s investment sector is hot, and net redemptions when popularity cools. A fixed asset pool makes it easier do what investors seek: buy low and sell high.

 

The current low interest rate environment has prompted several closed-end funds to seek added flexibility to allow them to better adapt to future changes – and investors seem quite receptive.

 

  • Added Trading Flexibility from the Start – After decades of almost exclusively income-focused new issues, several of 2013’s most popular closed-end fund IPOs feature broad investment latitude. While income is often an investment objective, a growing number of funds also seek growth of capital. To achieve these goals, new funds are beginning to embrace a wider range of investment choices, including many types of debt securities, preferreds, convertibles, and equity securities, with allowable holdings located worldwide, including in emerging markets. A chronological list of closed-end fund IPOs is available at Herzfeld Research.

 

  • Expanded Latitude for Existing Funds – The closed-end industry is moving toward greater trading flexibility, largely due to the evolution of underlying markets. For instance, dozens of closed-end municipal bond funds used to invest primarily ininsured municipal securities. However, as the prevalence of bond insurance waned, these funds found it necessary to change their investment restrictions and no longer require a specific level of investment in insured municipal bonds. Similar market-driven changes include the expansion of geographic investment areas for foreign funds, adjusting concentration requirements for specialized equity funds, adding derivative and option strategies, and allowing investment in new types of securities that did not exist when the funds were brought to market.

 

More recently, funds have begun to focus on the day when interest rates will start rising. For instance, some are allowing their portfolio managers to expand the types of income securities in which they can invest, adding the ability to alter duration and quality characteristics of their portfolios, and allowing or increasing the permissible use of derivatives.

 

  • Managing Multiple Forms of Leverage – For closed-end funds, the ability to be agile also extends to the use of leverage. The vast majority of funds use some form of leverage to magnify performance results (whether positive or negative) but, more importantly, to boost the potential income available to common shareholders.

 

Since 2008, leverage has undergone a dramatic change. Auction rate preferred shares had been the primary form of leverage, but now the industry uses more than half a dozen different types of leverage with varying costs, durations, and risk characteristics. In fact, it is quite common for an individual closed-end fund to have two or more types of actively managed leverage. Toward this end, funds also seek additional latitude to effectively manage their leverage, providing them the potential to preserve the benefits they offer, as well as to mitigate any negative effects.

 

A related trend is the increased number of closed-end fund mergers over the past few years. Part of the rationale behind many mergers is the added flexibility provided, specifically as it relates to leverage. A larger fund is in a better position to adjust allocations between fixed and floating rate forms of leverage, while it may only be feasible for a small fund to maintain one type of leverage.

 

Unprecedented Window of Opportunity

The current low interest rate environment is providing an unprecedented window of opportunity for closed-end funds to prepare for the future – and the industry is responding. After all, the best time to ask for more latitude is when things are going well, and for certain changes that may require a shareholder vote, now is an ideal time.

 

Thanks in large part to the ability of many closed-end income funds to offer competitive yields despite declining interest rates, these funds are enjoying an unusual level of popularity, as measured by their premium/discount valuations. As of early May 2013, the average closed-end fund is trading at a mere 2% discount below net asset value, while more than one-third of the industry is changing hands at a premium. Furthermore, all closed-end fund categories turned in strong, positive average performance results in 2012, and all but the municipal fund group added to those gains in the first quarter of 2013.

 

We believe granting closed-end funds greater investment latitude now not only strengthens the prospects for continued success and profitability of individual funds, but can also provide benefits to foster the continued growth of the industry as a whole.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.