Outside the Box: Looking for retirement income? You may find it in closed-end funds

Many older Americans look to their investments to produce income to meet their expenses during retirement. The need for these income-generating strategies is rising along with average life expectancy and the number of Americans in or near retirement.

However, the current, low interest-rate environment has made finding income difficult. Fixed-income investments no longer produce the reliable yields they have in the past.

Closed-end funds (CEFs) may help income-seeking investors to meet this challenge. CEFs issue a set amount of shares upon inception. They trade in the secondary market, such as on the New York Stock Exchange, and can be purchased through a brokerage account. No new shares of CEFs enter the marketplace after the initial public offering, unlike their open-end counterparts. Because CEFs trade on stock exchanges, supply and demand drive their prices. Shares may trade above their net asset value (at a premium) or below (at a discount).

CEFs may offer higher average yields than category peers, such as open-end funds and ETFs. This “closed” structure can serve as an advantage to managers seeking to generate reliable income.

While open-end funds need to keep a supply of cash on hand to meet daily redemptions, CEFs do not, since they trade on the secondary market. This single feature — freedom from daily redemptions — opens up advantages for investors.

Because they hold this cash to meet daily redemptions, open-end funds may be subject to a “cash drag,” meaning the cash is not generating returns. The manager of a closed-end fund only needs to hold cash to meet dividend payments at dates they are aware of in advance.

Additionally, CEFs provide investors with immediate exposure to the fund assets. Unlike investing in an open-end fund, with CEFs, investors immediately gain exposure to a fully invested portfolio. They do not have to wait for the manager to invest their cash.

The fixed pool of capital available to CEF managers may allow them to access a broader opportunity set and take a longer term view. For example, CEFs can offer access to private and real assets that are not readily available to individual investors in open-end funds and ETFs.

Illiquidity can be a source of higher income and returns, but is only suitable for investors who can tolerate the accompanying risk. For an open-end fund, illiquid investments can become an issue in times of market stress. During market downturns, investors may begin to pull their money out of the fund and the manager must sell assets quickly to raise the cash to meet redemptions. With CEFs, investors are still able to sell their holdings, but mangers are able to consider whether or not they believe it is an appropriate time to sell assets.

CEFs are able to use leverage to try to enhance the fund’s return, income or both. Leverage can significantly enhance portfolio income generation. It is a key reason that CEFs have by and large been able to produce more income than similar open-end funds over the long term. However, it is important to remember that leverage is not a free source of extra returns and does come with certain risks. As markets fall, leverage can amplify those losses. However, there are rules about how much leverage a CEF can use. Per the 1940 Act, leverage in CEFs is limited to two times asset cover for preferred shares or three times asset cover for bank borrowing and other forms of financing.

Because shares of CEFs trade on exchanges, they may also provide investors with intraday liquidity if necessary, similar to an ETF. This also means that the share price of a CEF will rise and fall in response to investor demand.

This may allow investors to purchase CEF shares at a discount to their underlying net asset value. If a fund is trading at a 10% discount, $100 worth of assets are available for $90. This not only provides added exposure to the assets, but also enhances the effective income yield for each dollar invested in the CEF. Buying a fund at a discount provides the potential for another source of return if that discount narrows. However, a discount also has the potential to widen further. It’s also possible that CEF shares may trade at a premium, meaning shares cost more than the underlying net asset value.

One way investors can incorporate CEFs into their investment line up is through core-satellite investing. This is a strategy to manage costs, minimize volatility, generate alpha and tailor a portfolio to an individual’s needs. The core of the account comprises a passive or beta-like exposure investments, then adding active strategy positions as satellites.

Investors can implement a core-satellite strategy by combining both passive and active strategies. To do this, they can use investment vehicles like individual securities, separately managed accounts, open-end mutual funds, exchange-traded funds and particularly closed-end funds.

As with all investment decisions, conducting proper due diligence is essential. However, as part of a balanced portfolio, CEFs may provide an attractive solution for those looking for extra income in their retirement.

Christian Pittard is group head of product opportunities at Aberdeen Standard Investments. He does not personally benefit from the sale of financial products discussed in this article.

Disclosure: 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.

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