1 IF YOU HAVE THE TIME The Long-Term Potential of Closed-End Funds vs. Open-End Funds Authored by Robert Kenyon, Managing Director, Business Development Closed-end funds have been on the market since 1893, more than 30 years before the first open-end fund (or mutual fund) became available. Nevertheless, demand for them has not been nearly as great as for their better-known siblings. At year-end 2013, the closed-end fund universe consisted of just 599 funds, down from a high of 663 funds in 2007, and had over $279 billion in assets under management. In contrast, investors had 7,707 open-end funds from which to choose, representing more than $15 trillion under management. 1 The significant disparity in assets under management is understandable given the differences in the basic structure of the two investment vehicles. Unlike open-ended funds, closed-end funds: > are usually closed to new capital and investors after their initial public offering (IPO); > do not buy back or redeem investor shares on a daily basis, whereas open-end funds may be redeemed at NAV; > trade during market hours on one of the stock exchanges or over the counter; and > often trade at a premium or discount to net asset value (NAV), much like an oil or technology company s share price will trade in relation to its book value. (These last two attributes have little or no effect on a fund s performance on an NAV basis.) Money flows regularly into open-end funds because they are, as their name suggests, open to new investors and additional dollars from current investors. Existing closed-end funds, on the other hand, are not. That said, closed-end funds deserve to be on the radar of many, if not most, investors because they have shown an ability to outperform open-end funds in the same investment category largely because of their structural differences. In theory, says Mariana Bush, CFA, senior analyst at Wells Fargo Advisors, a closed-end fund should perform better than an open-end fund. A Close Look at Closed-End Funds WHITE PAPER SERIES March 2014 The Differences Behind the Theory Yes, theoretically closed-end funds should outperform open-end mutual funds, in up markets and over time. Then again, in down markets, many closed-end funds will perform worse. The result in each case is due largely to several important differences that exist between closedend and open-end funds. In contrast to their open-end fund counterparts, closed-end fund managers don t have problems with asset flows, the first important difference. This includes inflows of dollars from new and existing investors, and outflows from selling securities to meet investor redemptions. This is fabulous for the portfolio managers because there s no pressure to sell when he or she doesn t want to sell and no reason to buy unless they want to, Bush says. It s also advantageous for the manager not to have to worry about flows because then he or she can invest in illiquid securities if the opportunity is right. Likewise, he or she can better manage taxes in the fund. So, for example, longer duration municipal bonds, lower quality corporates, master limited partnerships (MLPs), and emerging market debt may be more attractive to a closed-end fund manager than to an open-end fund manager who has to worry 1. Source: Investment Company Institute. Closed-end fund data as of December 31, 2013 ( Closed-End Fund Data release, March 10, 2014): open-end fund data as of December 31, 2013 ( Trends in Mutual Fund Investing release, February 27, 2014): stats/trends/ci.trends_01_14.print.
2 that a sudden and sharp increase in redemptions might force him to sell out of a position at an inopportune time. Some open-end funds deal with this by keeping some of the portfolio in cash in a liquidity bucket to meet redemptions, says Steven Pikelny, an analyst at research firm Morningstar, but that kind of warps the portfolio allocations. The closed-end structure eliminates that kind of hassle. Closed-end funds do have certain liquidity concerns, but they re more manageable, Pikelny continues. For example, they may need cash on hand to make distribution payments or to de-lever the portfolio, if necessary. Because of this relative stability of the asset base, closed-end fund managers can leverage those assets up to the limits allowed by the Investment Company Act of 1940, which is the second important difference. While open-end funds may also utilize leverage, it is much more commonly utilized by closed-end funds. Fixed income open-end funds tend to focus on maximizing total return good total return equals more assets in the fund, which equals greater fees. Closed-end funds, on the other hand, tend to be yieldoriented. And the main purpose of leverage is to give them higher yield, Bush says. The final important difference is that because closed-end funds trade on the open market, their prices generally rise and fall based on investor sentiment; consequently, they often trade at a discount or premium to the underlying NAV. Over short periods, price performance may be quite different from NAV. Over longer periods, it is generally very close to NAV. But because the share price is subject to supply and demand, there s an extra layer of volatility on top of what NAV will give you, Pikelny says. Thus, closed-end funds that trade at a discount present another opportunity to investors for additional return, one not available to investors in open-end funds. As the market discovers an undervalued fund, the discount between share price and NAV should narrow. That narrowing represents capital appreciation for the astute investor. So in a closed-end fund, the investor could get the capital appreciation on the NAV because of investment performance and on the share price because of a change in investor sentiment, Pikelny says. Testing the Theory The absence of asset flows, more liberal employment of leverage to enhance returns, and the potential for a narrowing of the NAV discount all are reasons why closed-end funds should outperform open-end funds. Unfortunately, proving the theory is problematic. Apples-to-apples comparisons that support the theory are difficult to find, but not impossible. Pikelny found two comparable high-yield funds, one open-end, the other a closed-end fund that eschewed leverage. In the second quarter of 2013, the open-end fund suddenly experienced substantial outflows. The closed-end fund, because of its structure, did not. When year-to-date performance came out at second quarter-end, the open-end fund had returned 3.6%. The closed-end fund, which followed the same strategy but did not experience any outflows, returned 4.7% on an NAV basis. According to Pikelny, both funds were fairly junky and therefore illiquid, which apparently hurt the open-end fund when it had to meet redemptions. While very limited, this was a good comparison because you find very few examples of similar funds, he reports. The comparison allowed us to isolate the effects of flows on performance. The story doesn t end there, however. The Federal Reserve s announcement during the second quarter of 2013 that it might begin tapering its monthly bond purchases sent the fixed income market universe including both open-end funds and closed-end funds into a tailspin. The closed-end fund I was studying totally gapped out and went from trading at NAV to around an 8% discount by mid-year, Pikelny says. Investors still did better on an NAV basis, but they probably would have been better off in an open-end fund because of the gap. Nevertheless, Pikelny s fund comparison supports the case that a closed-end fund s features should lead to better performance on an NAV basis over time. And the investor who bought that high yield closed-end fund after it gapped? That discount to NAV could eventually accrue to his or her benefit if and when the gap narrows. Of course, one fund comparison does not a proof make. To make a valid argument would require a sizable universe of closed-end funds and open-end funds with similar investment objectives, asset classes, managers, styles, and so on. Unfortunately, that large universe does not exist. In many cases where the funds appear to be comparable, they are actually different enough that the comparison would not be fair, Bush argues. Moreover, doing a study on just a few examples probably doesn t make much sense statistically. So if apples-to-apples comparisons of essentially identical closed-end funds and open-end funds are hard to come by, maybe a broader view using fund categories will give us some insight into the relative performance of the two types of funds a fruit-to-fruit comparison if you will. A Close Look at Closed-End Funds WHITE PAPER SERIES 2
3 Methodology Morningstar maintains performance data on open-end funds in 103 different categories, from aggressive allocation to world stock. Closed-end funds compete in 76 of those categories. Because we see closed-end funds as long-term investment vehicles pursuing long-term investment themes rather than as trading vehicles, we chose to look at 25 categories in which closed-end funds had a least seven funds with 5- and 10-year histories through December 31, For example, 85 closed-end funds in the muni national long category have 10-year track records over that period, while seven in the real estate category meet that criterion. Furthermore, we chose not to compare categories where fewer than seven closed-end funds competed because the sample would be too small. Finally, we compared both types of funds on a total-return-to-nav basis because we wanted to see whether the features of closed-end funds the absence of asset flows, the greater usage of leverage, and the influence of discount narrowing actually enhanced investment performance. The Findings Do the differences between open-end mutual funds and closed-end funds make a difference to the investor? At least over the 5- and 10-year periods ending on December 31, 2013, that appears to be the case (Figure 1). Over the last five years, which was a generally up market, closed-end funds outperformed comparable open-end funds in 88% of the 25 different categories we examined and by an average annualized total return of 3.45%. Likewise, 80% of the closed-end fund sectors we examined outperformed their comparable open-end fund categories over the 10-year period, but this time by an average annualized total return of just 0.44%. That result is understandable given the financial crisis that affected many closed-end funds worse than open-end funds due to the added impact of leverage. FIGURE 1: PERFORMANCE OF CLOSED-END FUND AND MUTUAL FUND CATEGORIES (THROUGH 12/31/13) 5-YEAR TOTAL RETURN 10-YEAR TOTAL RETURN FUND CATEGORY CLOSED-END OPEN-END DIFFERENCE CLOSED-END OPEN-END DIFFERENCE Bank Loan Convertibles Corporate Bond Emerging Markets Bond Equity Energy High Yield Bond High Yield Muni Intermediate-Term Bond Large Blend Large Growth Large Value Long-Term Bond Miscellaneous Region (Stock) Multisector Bond Muni California Long Muni National Long Muni New Jersey Muni New York Long Muni Pennsylvania Muni Single State Long Preferred Stock Real Estate Utilities World Allocation World Bond Average Outperformance by Closed-End Funds 3.45% 0.44% Percentage of Closed-End Funds that Outperformed 88% 80% Number of Categories that Outperformed (out of 25) Source: Morningstar. All returns are net of fees. See last page for total number of funds in each category. Past performance is no guarantee of future results. A Close Look at Closed-End Funds WHITE PAPER SERIES 3
4 Looking at both the 5- and 10-year periods, what stands out is that in four of the eight instances where a closed-end fund category underperformed the comparable open-end fund category, the difference in annualized return was less than 1.7%, and in three cases, less than 1.25%. In just three cases the large growth (both 5- and 10-year) and world allocation (10-year) categories was the difference more than 4% (Figure 2). Contrast that with the fact that over the last five years, 12 of 25 closed-end fund categories outperformed their open-end fund category counterparts by an annualized total return of more than 4%, and 17 categories did so by more than 3%. FIGURE 2: ANNUALIZED TOTAL RETURN OF CLOSED-END FUNDS AND MUTUAL FUNDS 5-YEAR Bank Loan Convertibles Corporate Bond Emerging Markets Bond Equity Energy High Yield Bond High Yield Muni Intermediate-Term Bond Large Blend Large Growth Large Value Long-Term Bond Miscellaneous Region Multisector Bond Muni California Long Muni National Long Muni New Jersey Muni New York Long Muni Pennsylvania Muni Single State Long Preferred Stock Real Estate Utilities World Allocation World Bond 0% 5% 10% 15% 20% 25% 10-YEAR 0% 2% 4% 6% 8% 10% 12% Source: Morningstar. Data as of December 31, Closed-End Fund Share Price Mutual Fund NAV Though the return differences are not as dramatic over the 10-year period, closed-end funds managed to beat their corresponding open-end funds in 13 of the 25 categories by an annualized total return of 1% or more, and seven did so by more than 1.5%. By comparison, during the financial crisis years of , both closed- and open-end funds generally suffered losses; however, closed-end funds underperformed in 24 of the 25 categories examined (corporate bonds was the exception) and by an average annualized total return of 9.4%. Conclusion So does this prove that investors should invest in closed-end funds rather than open-end funds? Of course not; however, the data does show that investors (even conservative investors) should at least consider closed-end funds for possible inclusion in their portfolios, especially if they are investing for the long term. In other words, if they have the time. When investing in closed-end funds, you want to have a long-term perspective given premium/discount volatility, says Jerry Raio, managing director and head of retail origination at Wells Fargo. If you take this approach, the closed-end fund market may offer attractive investment opportunities. A Close Look at Closed-End Funds WHITE PAPER SERIES 4
5 For information on Virtus Closed-End Funds, please contact us at or visit Figure 1 supporting data: For each Morningstar Category, total number of closed- and open-end funds compared: Bank Loan: 26, 253; Convertibles: 9, 90; Corporate Bond: 10, 153; Emerging Markets Bond: 11, 359; Equity Energy: 29, 167; High Yield Bond: 41, 723; High Yield Muni: 11, 180; Intermediate-Term Bond: 7, 1,112; Large Blend: 22, 1,662; Large Growth: 11, 1,781; Large Value: 9, 1,292; Long-Term Bond: 7, 40; Misc. Region (Stock): 17, 41; Multisector Bond: 32, 344; Muni CA Long: 26, 154; Muni National Long: 85, 252; Muni NJ: 12, 61; Muni NY Long: 21, 119; Muni PA: 10, 85; Muni Single State Long: 14, 310; Preferred Stock: 17, 41; Real Estate: 7, 274; Utilities: 8, 69; World Allocation: 10, 554; World Bond: 11, 422. Morningstar data used with permission Morningstar, Inc. IMPORTANT RISK CONSIDERATIONS An investment in a fund may lose value and shares may be worth less when sold than when bought. There can be no assurance that a fund will achieve its investment objectives. This information does not represent an offer, or the solicitation of an offer, to buy or sell securities. Shares of closed-end investment companies trade in the market above, at, and below net asset value. This characteristic is a risk separate and distinct from the risk that a fund s net asset value could decline. A fund is not able to predict whether its shares will trade above, below, or at net asset value in the future. When a fund leverages its portfolio, the value of its shares may be more volatile and all other risks may be compounded. There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. Events negatively impacting a municipal security, or the municipal bond market in general, may cause the fund to decrease in value. Emerging markets securities will be more volatile, or more greatly affected by negative conditions, than those in more established foreign markets. Investments in Master Limited Partnerships may be impacted by tax law changes, regulation, or factors affecting underlying assets. VP Distributors, LLC, member FINRA and subsidiary of Virtus Investment Partners, Inc Virtus Investment Partners, Inc.