Financial advisers on the hunt for income should be keeping a close eye on closed-end funds, where yields are double and triple those of traditional mutual funds and exchange-traded funds.
The average equity closed-end fund had a one-year yield of 5.7% as of last Monday, while the average equity income mutual fund had a yield of 2.3%, according to Morningstar Inc.
Many advisers overlook the income opportunity in closed-end funds, though, because of their unique structure, Anne Kritzmire, managing director of closed-end funds at Nuveen Investments, said at a recent conference in New York.
“The income benefit is what resonates the most with investors, but the biggest hurdle is advisers [who] don't understand them,” she said at the Capital Link Close-End Fund Forum. “Closed-end funds give you more, and that means more ¬complexity.”
Closed-end funds have a fixed number of shares that trade intraday on an exchange. Because the amount of shares is finite, they tend to trade at a discount or premium to the net asset value of the fund's underlying securities.
The funds also are able to use leverage — something that traditional mutual funds don't do — as the primary way to boost their income distributions.
“Leverage enhances yields and adds more volatility,” said Mariana Bush, a closed-end-fund and exchange-traded-products analyst at Wells Fargo Advisors.
“For some advisers, that would be one reason to stay out of the fund; for another, it could be a reason to stay in,” she said.
One thing that advisers can do to protect themselves when looking at closed-end funds is to make sure that the yield promise isn't too good to be true, Ms. Bush said.
An unreasonably high yield — say, more than 10% for an equity fund — could be a sign that the fund is stretching too far in its search for income, she said.
Since the start of the year, investors have shown greater interest in closed-end funds. The two largest initial public offerings of closed-end funds since 2007 occurred in the first four months this year.
The Pimco Dynamic Credit Trust Income Fund (PCI) raised $3.2 billion in January, and the DoubleLine Income Solutions Fund (DSL) raised $2.3 billion two weeks ago.
Although both those funds are taxable-bond funds, some experts see the best values in closed-end funds among the equity funds.
The average equity closed-end fund is trading at about a 4% discount to its NAV. The average taxable-bond fund is trading at a slight premium at the same time.
Select list
“One of the things we look at is discount valuation,” Ms. Bush said. “It helps us avoid areas that are overbought.”
As a result, the select list at Wells Fargo now includes “many more” equity funds than taxable-bond funds.
Advisers shouldn't let the discount scare them away, but it is something on which they need to keep an eye, said John Cole Scott, a portfolio manager at Closed-End Fund Advisors.
“The discount doesn't have to narrow to make money,” he said. “It just can't widen dramatically.”
There is even a slice of equity closed-end funds that could appeal to leverage-averse advisers. Closed-end funds that write covered calls generate extra income by selling call options instead of using leverage.
“If you're looking for income and equity exposure, it could be a good place to get it,” said Cara Esser, a closed-end-fund analyst at Morningstar.
“The biggest risk is, you don't get as much on the upside, because you're writing away some of your profits with the call,” she said. “The trade-off is, they won't lose as much, on a relative basis, in a down market.”
The average covered-call equity closed-end fund has a 9% yield.
Dorothy Bossung, executive vice president at Lowery Asset Consulting LLC, finds closed-end funds appealing because of their income, but she thinks it is easier to outsource the legwork to a third-party manager.
She uses closed-end-fund strategies run by RiverNorth Capital Management LLC or Parametric Risk Advisors LLC.
“Some clients really, really focus on income generation,” she said.
