Five reasons to consider closed-end funds in your portfolio

Closed-end funds (“CEFs”) can play an important role in a diversified portfolio as they may offer investors the potential for generating capital growth and income through investment performance and distributions. Over time, CEFs have evolved to include a variety of asset classes and investment strategies to accommodate the objectives and risk tolerance of a wide range of investors.

Five reasons to consider closed-end funds in your portfolio

• Potential for attractive distributions
• Efficient portfolio management
• Enhanced returns (via the illiquidity premium and leverage)
• Premiums/discounts
• Intra-day liquidity

Potential for attractive distributions

CEFs typically pay distributions on a monthly or quarterly basis. In many cases, CEF distribution rates exceed those of comparable investment vehicles such as open-end mutual funds (Exhibit 1). Investors generally have the option of receiving distributions in cash or having their distributions reinvested. By automatically reinvesting dividends, investors purchase additional CEF shares on an ongoing basis, which has the potential to lead to higher future returns. Closed-end fund distributions may be derived from various sources of a fund’s return, including interest, dividends, capital gains and potentially return of capital — the composition and tax treatment will vary for each fund depending on its underlying holdings and portfolio turnover. A return of capital may occur, for example, when some or all of the shareholder’s investment is paid back to the shareholder. A return of capital distribution does not necessarily reflect the Fund's investment performance and should not be confused with ‘yield’ or ‘income’. When distributions exceed total return performance, the difference will reduce the Fund’s net asset value per share.

Exhibit 1: CEFs may offer higher distribution rates than comparable investment vehicles such as open-end mutual funds

Efficient portfolio management

Usually, once a CEF completes its initial public offering (“IPO”), the number of shares outstanding is fixed. Following the IPO, a CEF’s shares trade in the secondary market on a stock exchange and are usually not subject to redemptions by the shareholder. This means that portfolio managers can keep the fund fully invested and do not have to keep cash on hand to meet redemptions like they would in a open-end mutual fund.

Enhanced returns: Illiquidity premium and leverage

The efficient structure of a CEF also provides greater flexibility in the types of securities and investment strategies that portfolio managers can utilize, such as employing leverage to potentially enhance distributions and investing in more opportunistic and/or less liquid securities in seeking to generate higher returns.

Illiquidity premium: CEFs provide access to unique investment opportunities can offer higher income and return potential by harvesting the illiquidity premium. The illiquidity premium refers to the incremental return that an investor may receive for owning an asset cannot easily be converted to cash at fair market value.

Leverage is a strategy that can be employed by CEFs in an effort to achieve a higher rate of distributable income and potentially enhance returns. Leverage seeks to profit from the spread between short-term (lower) and long-term (higher) interest rates, assuming an upward sloping yield curve, by borrowing at short-term interest rates, or issuing preferred stock, and investing the proceeds in longer-term securities that may pay higher rates of return. Although there are several potential benefits of using leverage, investors should consider the potential for increased risk and volatility prior to investing in a leveraged CEF.

Premiums/discounts

At any given point in time, a CEF’s share price may be above or below its underlying NAV, which is referred to as the CEF trading at a premium (market price is above NAV), or discount (market price is below NAV) to NAV. Premiums or discounts are the result of a combination of a number factors including, but not limited to, market and investor sentiment, fund specific characteristics, and/or manager and firm recognition. BlackRock believes that it may be advantageous to purchase a fund when it is trading at a discount to its NAV, since each dollar invested purchases more than a dollar of net assets. If the discount begins to narrow, investors may also have greater potential for capital appreciation.

Exhibit 2: Some potential drivers of premiums and discounts

Intra-day liquidity

CEFs are typically listed on a major exchange such as the New York Stock Exchange, although, there is no guarantee that a market for listed closed-end fund shares may be established or maintained. This provides the benefit of liquidity and the convenience of being able to track an investment with its assigned ticker symbol throughout the day. As a result, an investor can transact in CEF shares throughout the trading day at the current market price. This compares to an open-end mutual fund, where an investor is limited to purchasing or selling the fund once a day at the close of business at net asset value (“NAV”).