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YOU’VE PROBABLY HAD the same experience I’ve had when shopping for clothes. Spring’s in the air—a great time to take advantage of the local clothing store’s annual winter clearance sale. You buy that Ralph Lauren cashmere sweater at 20% off and jaunt home basking in glory. But the next day, while out for a walk, you peek at the store’s window display and see the same sweater, but now marked down 30%. You return home bemoaning your impulsivity.
Welcome to the befuddling world of closed-end funds.
The proclamation that closed-end funds can be bought for a 10% or bigger discount is no less tempting than that handsome sweater. But it’s just a come-on. How so? All closed-end funds have two prices. There’s the market price at which you can buy and sell—and then there’s the net asset value, which is the value of the fund’s holdings expressed on a per-share basis.
The good news: The market price might be below the net asset value, allowing you to buy the fund at a discount. The bad news: Unlike a regular mutual fund, there’s no guarantee you can sell your closed-end fund for its net asset value. Instead, you must trade at the market price, which bounces around with the mood of the market.
Still, if a closed-end fund owns stocks you’d like to have in your portfolio, it might be a good candidate for purchase, but only if the current discount is greater than the usual discount over, say, the past five years. Timing—a dicey dalliance in its own right—holds the key. A closed-end fund’s discount is typically largest when its stock portfolio is most out-of-favor.
To see how much premiums and discounts can fluctuate, let’s look at BlackRock Health Sciences Term Trust (symbol: BMEZ), a closed-end fund focused on smaller health and biotechnology names.
The BlackRock fund’s discount is currently almost 15%, versus a 9% average over the fund’s history, which means the fund is attractive, though not as big a bargain as it has been. Back in December, before the recent health tech revival, the discount was a whopping 18%, perhaps an opportunity for a high-wire deep value investor, but a catastrophe if you were out of Xanax or needed to sell.
Indeed, in 2022, the BlackRock fund’s portfolio declined 23% but its market price plunged 33%. That plunge might seem especially surprising given that the fund sells options on about a fourth of its portfolio, a strategy designed to limit losses.
Providers of closed-end funds are quick to glorify their very high distribution rates, often mistakenly referring to them as dividends. Annual distributions can exceed 10% of a fund’s share price, are usually paid monthly, and are artificially made to appear smooth and predictable, a marketing ploy to attract retirees and other income investors. How can the distribution rates be so high? It’s flimflam.
Here’s how it works. Closed-end fund distributions are paid from three main sources: dividends, capital gains and a category aptly named “return of capital.” If Vanguard Group’s health care fund (VGHCX) yields less than 1% and Fidelity’s biotechnology offering (FBIOX) hardly anything at all, how can the BlackRock fund throw off about 10%? It can’t, at least not without some skullduggery. When dividends and capital gains meet expectations, all is well and the BlackRock fund’s distribution cruises at almost 1% a month without robbing the net asset value of your investment.
But what if the BlackRock fund’s dividends and market gains fall short of the desired distribution? How can the fund managers possibly make good on their effort to maintain a high monthly payout when we know that the average dividend of smaller health growth stocks is about 1% a year? The standard fix for the small but devoted closed-end fund community is simple but hardly kosher.
Like many closed-end funds, BlackRock Health Sciences plugs some of the leak by reaching into your own money as part of the “distribution,” a practice known as destructive return of capital. What if the distribution rate eventually proves unsustainable? A fund will cut its distribution. This precipitates pandemonium in the fund’s price as all those hoodwinked income investors bail.
Consider the payout for BlackRock Health Sciences over 2023’s first four months. Each month’s distribution was 14½ cents a share, so we’ve met the constancy criterion. According to Morningstar, January’s distribution was paid from short-term capital gains, another promise kept. But the picture turns grim in February, March and April, when the 14½-cent distributions were merely a return of shareholders’ own money. There’s your ill-gotten twist on the proverbial money back guarantee.
The litany of closed-end fund sins and drawbacks doesn’t stop with return of capital. Expenses for the Vanguard and Fidelity funds are 0.3% and 0.72%, respectively, whereas the comparable figure for the BlackRock fund is 1.32%. Even that is low compared to many closed-end funds, which are vestiges of the high-fee fund era of yesteryear. And remember, unlike mutual funds which are transacted at their closing net asset value, closed-end funds are bought and sold like stocks during the trading day. Because most closed-end funds trade on light volume, they’re subject to uncommonly large bid-ask spreads.
But why worry about such nonsense? Today, there’s no need to—thanks to the flourishing worlds of index-mutual funds and exchange-traded index funds.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.
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I have owned a small percentage of my portfolio in a handful of CEFs for the past decade, both equity and debt. I use them to bolster my pension. Other investments undoubtedly could have beat them on a total return basis but their consistent and regular distributions fit my needs and I am satisfied. I pay particular attention to the return on net asset value to avoid a self-consuming asset. Bear in mind that option income is typically categorized as return of capital, albeit non-destructive. Certainly, CEFs are not for everyone.
You are obviously (and unusually) sophisticated enough to monitor CEFs. But two caveats. As you know, the problem with the distributions isn’t the non-destructive ROC of the option income, but with the destructive ROC of any shortfall. You are right to be diligent about the critical issue of NAV erosion. That’s why it is so important for you to keep your eye on total return and not just the size of the distribution.
I also just want to mention how frustrating option-income CEFs can be when the market comes off a bottom. The lag can be substantial. Of course, so long as your goal is consistent and regular distributions, this would not be a major concern. Thank you for a very sophisticated response.
Thanks Steve, that is the simplest and most concise explanation for CEFs ever. Most investors are only presented the “fluff”.
Thank you. I’m not sure you’re right, but I’ll take it!
Hi Steve, after reading your article, I thought it sounded vaguely familiar to a video by Patrick Boyle that I watched the other day:
https://www.youtube.com/watch?v=SNlXayG_9b8
Forgive me, but I got Blackstone and BlackRock confused, lol. And a non-publicly traded REIT vs a HealthSciences fund (whatever that is), but I think the message is largely the same: be careful about buying stuff that’s hard to sell, and is hard to understand. Thanks for the reminder, and an informative behind-the-scenes look.
Thanks. Sorry it has taken so long for me to respond.
Unfortunately, I think the complications that seem inherent in most investments and strategies work in the favor of the asset management industry. The more complicated they can make investing look, the more people will think they need “professional” advice. Against that backdrop, it takes a lot of courage and conviction to have faith in the astonishingly simple method of saving monthly, investing broadly and cheaply and letting economic growth and compounding do the heavy lifting. Oh, to be 20 again, but with the investment wisdom of old age!
“Oh, to be 20 again, but with the investment wisdom of old age!” A common lament among retirees, certainly this retiree.
Solved with one word, Vanguard!
Well said, Steve!
Sounds like the best thing to do is get out right before the distribution is cut. (The “jig-is-up” moment.) Obviously, that would require impeccable timing or inside information, though.
And I don’t have either one!
Hello Steve, I’m too lazy to search but didn’t you post about CEFs several months ago? I recall it as a more positive review.
Perhaps I’m doing myself a disservice when I simply buy and hold CEFs long term. Over the years the returns have been consistently high. It appears that I could sell them for a higher price than I paid. Admittedly, I can’t know that till I actually attempt to sell.
I’m sort of disagreeing with you, but I wish I could better convey my feelings of respect. Your replies have always set the standard for civility.
Hi M Plate
I think Jonathan is right about that.
It’s fine to disagree with me!
I’m still a little concerned. Here are two quick ways to see if your assumption is correct. Take a look at the price you originally paid and the current price. Depending on how long you held it, you should find a substantial increase. When CEFs resort to return of capital, the money comes out of the net asset value of the fund and erodes the price. If your fund is engaging in that practice, you may find that the increase in price is much smaller than you might expect given the increase in the market over the same time period.
A more definitive way to check on your CEFs total return is to use Morningstar’s performance table. Try this. 2021 was a good year, last year was not. Find how your fund did in each year compared to the funds in its Morningstar category. This should give you an idea of how relatively well your fund did in an up and down market.
You can also get a more visual idea by checking out the long-term cumulative return of the fund on its Morningstar graph. How much money did the fund make for you over the last 10 years relative to its benchmarks?
If all these checks are okay, then you are probably right and you have done well. Just remember, you are probably paying a very high management fee and that when you do decide to sell you may want to set a limit price so as not to be victimized by what may be a large bid/ask spreads.
Thanks so much for what you said about my “civility.” I try to remember readers are taking time out of their busy day to write in.
I believe you may be thinking of a Mike Flack piece:
https://humbledollar.com/2022/08/in-praise-of-active/
I stand corrected. Thank you
M Plate, I can understand the confusion as both well written articles were authored by two rather good looking gentlemen.
Btw: Black Rock’s 1.32% expense ratio makes beating the market impossible.
Ha ha. My mother thought I was good looking but my wife Alberta would be surprised that I’m a gentleman. I read your article, too, and learned from it.