The Constraints on Closed-End Fund Managers

In the past, I have been critical on the topic of why you shouldn’t buy closed end funds because they tend to employ significant leverage in an effort to use debt to buy additional assets that can provide capital appreciation and higher dividend yields. During the 2009-2016 measurement period, this moderate leverage strategy worked out well because interest rates were low and the markets moved upward with little volatility.

When interest rates rise, you need higher total returns from the selected investments to keep the gap consistent. That is to say, when you borrow at 3% and earn returns of 9%, that 6% difference represents the value created by your use of leverage. If you borrow at 5%, you have to earn 11% returns at the higher market levels to maintain the same effect, while also exposing yourself to a risk I call “the tyranny of compounding” that refers to the capital destruction that will occur if the chosen investment delivers results below 5%.

I bring up the effects of leverage on most closed-end fund because I find it important to keep in mind that the often touted advantage of investing in closed-end funds is not actually an advantage after all.

I have read articles praising closed-end funds by noting that the management team doesn’t have to manage the cash position of the portfolio with an eye towards redemptions like you see with the management of mutual funds.

In theory, this is true. If the markets falls, and 10% of a regular mutual fund’s shares are redeemed, and the mutual fund only has 5% cash on hand, it will have to sell 5% of its stocks that have fallen in price to meet redemptions. It will probably have to sell another 5% of its holdings to create a new cash cushion for future redemptions. This means that if you own a mutual fund, the panic of other investors during poor times will affect you because the fund manager will have to sell undervalued shares to meet redemptions.

The holdings of mutual funds ebb and flow with the size of an investor base. If a mutual fund has 5% of its assets in Exxon Mobil, and 20% of investors sell their mutual fund shares, the fund will only own 0.8x of its original Exxon position unless it chooses to reduce some other stock or lower the proportion of available cash on hand to meet distributions.

With closed-end funds, the theory goes, the management team has a relatively free hand to make investments because it is not bound by the same institutional constraint. If a closed-end fund owns 1,000 shares of Exxon, and some market panic occurs to drive down the price of equities, the 1,000 XOM position need not be disturbed.

This is because a closed-end fund trades like a stock. It has an initial capital raise / IPO event, and then the price of the closed end fund trades independent of its net asset value. A closed-end fund manager does not have to sell assets to meet withdrawals, and therefore, it is often argued that they can take actions that are in the best long-term interests of fundholders rather than get caught up in short-term optics and volatility that affects traditional mutual funds.

The reason I mention that this advantage exists in theory is because closed-end funds are loaded with leverage. As of the end of 2016, the average publicly traded closed-end fund in the United States consisted of 23% leverage. And that leverage contains covenant restrictions that are analogous to margin calls. If Exxon falls by 30%, the closed-end fund manager may have to sell some of the stock at this low point to comply with the lender’s terms of the loan.

It is the same problem, just a different beneficiary. With a mutual fund, forced sales occur by operation of the inherent structure that now contains less assets. With a closed-end fund, forced sales occur by operation of a debt covenant with the lender that has the net effect of reducing the closed-end fund’s assets. The concept is correct that closed-end funds can immunize themselves from volatility, but it is only possible if the fund refrains from taking on debt. This is exceedingly rare, and as a consequence, closed-end funds bear the same risk of forced sales during market declines that you see with regular mutual funds.

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