Understanding Closed End Funds In ETFs

September 21, 2018

Closed-end funds (CEFs) don’t get a whole lot of love in the ETF world.

CEFs are portfolios of securities that pay out dividends and capital gains distributions, but, unlike ETFs, they can’t create or redeem shares on a daily basis. Instead, CEFs come to market with a fixed number of shares. They trade intraday, which means CEFs often trade at premiums or discounts to their net asset value.

Some say part of ETF investors’ lack of interest in CEFs is due to an education gap on what closed-end funds offer. A lot of CEFs today came to market in the 1980s, and new issuance is rare. A lot of investors don’t know how they work, or even why they should care.

The other part of the issue is the ETF wrapper itself—the advent of the easy-to-trade ETF structure cast a long shadow on CEFs.

But some ETF issuers are looking to change that conversation. By highlighting the appeal of CEFs—namely, they’re attractive income producers, and, often, good value plays—they are bringing to market ETFs that invest in CEFs, combining the popular ETF structure with the traits unique to the CEF wrapper.

Leah Jordan, vice president of Investor Relations at Saba Capital Management, chatted with us about this underfollowed space, offering the following tidbits:

(Saba is behind the Saba Closed-End Funds ETF (CEFS), launched in 2017. The fund has $26 million in assets under management and has an expense ratio of 2.6%.)

 

Ticker CEF ETFs AUM ($M) Exp Ratio
PCEF Invesco CEF Income Composite ETF  726 2.07%
CVY Invesco Zacks Multi-Asset Income ETF  281 0.88%
CEFL ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN  252 0.90%
YYY YieldShares High Income ETF  199 2.02%
XMPT VanEck Vectors CEF Municipal Income ETF  117 1.56%
FCEF First Trust CEF Income Opportunity ETF  45 2.78%
CEFS Saba Closed-End Funds ETF 26 2.62%
MCEF First Trust Municipal CEF Income Opportunity ETF  13 2.11%
GCE Claymore CEF Index-Linked GS Connect ETN  7 0.95%

 

  • People often say CEFs are different, esoteric, niche products.

However, that’s not true. In reality, CEFs are hardly niche. Today roughly one in five tickers on the New York Stock Exchange are closed-end funds. They command almost $250 billion in market value. And they can invest in just about anything.

“We like to call ourselves here at Saba the jumbo shrimp—the biggest players in a small pond,” Jordan said.

  • ETFs as a wrapper have displaced demand for CEFs.

This is partially true, according to Jordan. Issuance and demand have dropped because of the dawn of ETFs, which offered a low-cost way for investors to “get in and out.”

ETFs and CEFs are pretty similar except for the creation/redemption mechanism. ETFs can create and redeem at any point, whereas CEFs have a fixed number of shares at launch.

  • CEFs are a value play, thanks in part to ETFs.

Sometimes, yes. Currently, absolutely. Because CEFs have a fixed number of shares, demand to buy or to sell can cause the fund to deviate from its net asset value. Right now, a lot of CEFs are trading at 10-15% discounts, offering investors access to stocks and bonds at a fraction of their price, according to Jordan. This level of a discount isn’t “normal,” but it can happen.

“Historically, these are products that have oscillated between a premium and a discount, and most of them were at their deepest discounts in '08. But in 2013, the taper tantrum brought the entire fixed-income CEF universe to a discount and they just never bounced back,” Jordan said. “What's unique about this point is that there aren't a lot of things at a discount right now; valuations are very high.”

That makes the opportunity in CEFs compelling, she says. And yet demand is sluggish. One of the reasons CEFs are struggling to go back to a premium is because of ETFs themselves. As a wrapper, investors can simply get similar exposure in an easy-to-trade ETF instead.

  • CEFs are great for income, but retail may be missing out.

No doubt about it. CEFs typically offer attractive yields because they pass through capital gains and income as cash dividends to investors, Jordan says. And when they are at discounts, yields are even more sustainable, she notes, particularly in the fixed-income space, as lower bond prices mean higher yields. CEFs are great income producers.

“CEFs are yielding 8.5%, 9%. You’d think they’d be flying off the shelves,” Jordan said. “But we're in a world where people are not behaving rationally. The universe is heavily retail-dominated, and when retail wants out of something, selling drops price, which begets more selling, and it's kind of this snowball effect. That’s where we are today.”

“We're actually at some of the widest discounts in history, and at a time when assets are at an all-time high,” she added. “It’s taking CEFs a long time to mean-revert.”

  • A CEF ETF is a bet on an active manager that’s betting on other active managers.

CEFs are actively managed. ETFs investing in CEFs often are too. As an investor, you are trusting that the ETF’s portfolio manager is picking the right CEF managers for the portfolio. The whole process is about trust and confidence in active management, no doubt.

But there’s a burgeoning trend among managers in this space that is investor friendly. It’s so-called activism, where managers will step in if the discount persists or gets too wide, and take action to narrow it whether it's through a tender or liquidating NAV, according to Jordan.

“Activism has become very prominent in this space, and that's something that didn't exist really before,” she said. “BlackRock doesn't like its name trading at a discount. Pimco hates its name trading at a discount so much that it makes special distributions to inflate their yield, and a lot of their CEFs trade at a premium, so people see the 13% sticker yields and there's a lot of appetite for that. This type of shareholder-friendly manager helps provide a floor to the discount.”

  • The ETF wrapper works well for CEFs, but it’s expensive.

ETFs are great wrappers for CEFs, Jordan says, because ETFs are predominantly a retail-oriented product, and that was “originally the idea of a closed-end fund as well.” Today more than 75% of CEFs are held by retail investors.

The ETF wrapper also makes the CEF universe more accessible. Today investors can own a number of CEFs in one transparent wrapper.

But active management often translates into higher fees, and in the CEF space, that’s totally true. It’s a diverse universe, but it’s not rare to see CEFs charging a 3-4% expense ratio—at those prices, it can be really difficult to beat an index, especially on the equity side.

The bulk of the price tag comes from the cost of the underlying closed-end funds that go into the portfolio. Consider Saba’s CEFS, for instance. The ETF costs 2.6%, and about 1.5% is currently the acquired funds fee. That fee is also not constant, as portfolio holdings change, so these ETFs’ expense ratios are moving targets.

Contact Cinthia Murphy at [email protected]

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