Exactly a year ago we discussed how investors can go about making the choice between a closed-end and an open-end fund. Much has changed in the market since then so we take this opportunity to revisit our framework and see whether the developments over the past few months shed any additional color.
We have two key takeaways in this article. First, the choice between ETFs and CEFs will depend on both the market environment and the characteristics of the individual sector. And secondly, different investors will find different approaches more or less useful depending on their investing style. This is why we present three different approaches for investors to pick from.
Because we recognize that each investor is different, our own service Focus List features both open-end and closed-end funds, often from the same sectors to give investors a best-of-breed option without being overly prescriptive.
We use the preferreds sector in the discussion below. In this sector, longer-term historic returns have shown that active funds have performed best.
A Quick Rundown Of Major Differences
Although there are many types of funds such as ETFs, mutual funds, closed-end funds, interval funds, private funds, and others, in this article we focus on the exchange-traded options: ETFs and CEFs.
Let’s consider some of the key differentiating factors between these funds.
CEFs tend to boast a higher yield than ETFs. This is typically due to the CEF use of leverage or, for some equity CEFs, a managed distribution policy which effectively converts capital gains into distributions. CEF leverage also allows these funds to drive higher longer-term returns, all else equal. Leverage can be a double-edged sword, however, as it can lead to increased fund volatility, steeper drawdowns and potential permanent capital loss due to deleveraging at inopportune times.
CEFs tend to trade at prices that diverge from their NAVs creating discounts or premia while ETFs tend to trade at their NAVs. It’s important to keep in mind, however, that just because a CEF is trading at a discount doesn’t make it a “good deal”. CEF discounts have a fair-value which is driven by the fund’s fee, leverage, cost of leverage and other factors.
CEFs are active investment vehicles while ETFs are mostly passive. In our last analysis we found that in fixed-income, CEFs outperformed ETFs whereas in equity sectors CEFs struggled to outperform ETFs.
CEFs tend to boast fees that are higher than those of ETFs though they are typically less than the additional yield that CEFs can generate through leverage. For unleveraged equity ETFs, however, high fees can significantly eat into returns which is why we have found that equity CEFs have tended to underperform popular equity indices.
CEFs can hold more illiquid assets as they don’t need to actually transact in the underlying securities to manage fund flows which is instead done on the secondary market. This allows CEFs to tap a broader set of assets than are available to ETFs.
CEFs have higher volatility due to additional leverage as well as the discount dynamic. This can create an additional set of behavioral issues with investors potentially selling during a drawdown and buying back at higher prices.
CEFs can issue additional shares by holding rights or at-the-market offerings which can be either accretive or dilutive to the NAV. They can also repurchase shares in the market such as when discounts are overly wide.
Thinking About The Choice
That’s quite a long list of considerations and it’s far from complete. Moreover, not all of these factors are equally important to different investors. So, what can investors do to simplify the choice between CEFs and ETFs?
We propose three different decision frameworks based on the type of investment style. This is not to say that each individual investor will fit neatly into only one type, however it does help to clarify the key decision choices for investors.
In the sections below we go through each of these three decision frameworks.
1. Historic Performance Approach – Total Return Investors
For some investors the historic total return is the major factor driving the choice of fund. These investors tend to be long-term buy-and-hold and focus more on maximizing total wealth rather than levels of income.
For investors with a constructive view in a given sector we can look at the percentage of CEFs in a given sector that have outperformed sector ETF benchmarks in NAV terms to guide this decision. Because ETF benchmarks that are used in this comparison are the same for the entire sector they are not perfect choices for each individual fund, however the analysis is still worth doing.
The chart below shows that there are only a few sectors in which the majority of CEFs have outperformed the sector ETF benchmark.
Source: Systematic Income
Arguably looking over the last 5 years is not a fair period because asset prices across stocks and bonds have risen sharply in that period. So, this kind of analysis will likely favor CEFs over ETFs. That said, it’s not exactly a slam-dunk result for CEFs. Many CEF sectors, have exactly zero funds that have outperformed sector ETFs over the last 5 years. This is quite surprising, particularly for CEF sectors that remain very popular with retail investors such as utilities. To avoid cherry-picking dates we looked at longer time frames, however the results were not very different.
We like using this approach because by looking at historic NAV performance we combine a number of key drivers of CEF vs ETF performance such as fees, leverage, portfolio quality, active vs. passive alpha and others. The upshot of the chart above in our view is that CEF sectors like preferreds and munis have easily outperformed sector ETF benchmarks, however other sectors have struggled, particularly EM sectors, TIPS and utilities. Investors in these sectors may want to take a harder look at the available ETF options.
2. Marginal Yield For Marginal Risk Approach – Yield/Income Investors
Another way to approach the CEF vs ETF question is to ask what additional yield we are getting by going with a CEF versus what additional risk we are taking on. We can then compare this additional or marginal yield for the marginal risk.
To motivate this approach, let’s first take a look at what yields are on offer via different fund wrappers. In our Strategic Allocation Tool we track average yields across ETFs, CEFs and mutual funds across different income sectors.
For example, in the preferreds sector we have open-end yields that are about 6% and CEF yields that are about 8%. The differential between the closed-end and open-end funds in this sector has historically been around 2-3%.
Source: Systematic Income
Now let’s take a look at the additional “risk” that these different fund types have historically carried. There is no perfect way to measure risk and no single definition will satisfy everyone. We like to use price drawdowns as they are relatively intuitive. The chart below shows that CEFs in the preferreds sector have tended to deliver drawdowns that are about twice that of open-end funds. For instance, in this last episode CEFs fell about 50% in price while open-end funds fell about half that level.
Source: Systematic Income
There are two important points to consider about such sharp CEF drawdowns. First is the behavioral one – different investors will respond differently to a 50% CEF drawdown. Some will double down, seeing an opportunity and others will sell in the middle of the drawdown locking in permanent losses.
The second point is outside of investor control and has to do with the fact that at some point through the drawdown, CEFs carrying leverage will need to deleverage. Although some funds have more or less need to deleverage no leveraged CEF can remain fully invested in a big-enough drawdown. As we have discussed in our past articles, deleveraging can often lead to a permanent capital loss, particularly in a mean-reverting market envionrment as well as a lower level of income generation going forward.
To summarize this approach, by comparing the 2% additional yield of CEFs over ETFs against the relative and absolute historic drawdown of various fund types, income investors can make a more informed choice of whether that additional yield offers sufficient compensation for the marginal drawdown.
3. Valuation Approach – Value Investors
Investors who like to make investment decisions based on value may take a different approach to the ETF vs CEF question.
There are two value considerations in the fund space. The first is the value of the underlying asset itself. This is often gauged by using various metrics such as yield and credit spreads in fixed-income and valuation ratios in stocks like P/E, P/B and others.
If we stick with the preferreds sector in our analysis, the best indicator of valuation is credit spreads or the spread over “risk-free” instruments like Libor or Treasury yields. The chart below shows the median spread over Treasuries of the retail preferreds market. By this metric the valuation of the preferreds market is very attractive.
Source: Systematic Income
Credit spreads can be somewhat unintuitive and they also do not pay bills. Most investors are familiar with yields so let’s take a look at the yield range of this market over the past 5 years. By this metric, the preferreds market is on the expensive side as the current yield is close to the 5-year low. This, however, hides the fact that Treasury yields have collapsed in the last few months. Our own view here is that the preferreds sector is quite attractive if we compare the yield of the sector to the risk-free alternative.
Source: Systematic Income
Investors looking at CEFs have to deal with another valuation point – sector discounts. For instance, tight sector discounts indicate that the CEF sector is on the expensive side and vice-versa. This suggests that in a period of tight discounts investors may be better off holding ETFs and in a period of wide CEF discounts they may be better off holding CEFs.
Let’s take a look at the 5-year range of CEF sector discounts presented by the box-and-whisker plot chart below which shows the trading range of sector discounts. The top and bottom edges of the box correspond to the 25th and 75th percentile and the whiskers correspond to the 5th and 95th percentiles. The horizontal bar in the box is the median discount over the last 5 years.
Source: Systematic Income
We can see that the preferreds sector discount is on the expensive side at the moment at around 1.5%. This suggests that the CEF preferreds sector is less attractive at the moment on a discount valuation basis.
Combining the two valuation levels offers a mixed picture for preferreds CEFs – although the underlying asset valuation is attractive, CEFs appear on the expensive side from a discount valuation perspective.
A Summary For The Preferreds Sector
What can we say about the preferreds sector in aggregate based on these three approaches. In our view there are three key takeaways:
- The CEF outperformance chart above suggests that active management appears to have delivered significant outperformance in the preferreds sector, so for this reason we would tilt to active vehicles in the preferreds sector such as CEFs, mutual funds or active ETFs.
- Whether the 2-3% pickup vs a 2x price drawdown in the preferreds sector is a choice for each individual investor. Our only advice here would be that investors going with CEFs think carefully about their CEF selection in order to minimize the chance of permanent capital loss due to poorly timed CEF deleveraging such as we have seen in a number of First Trust or Nuveen CEFs in March.
- On the valuation front we have a mixed picture. We still find value in the underlying preferreds market due to very wide credit spreads and decent yields. However, the CEF sector discount strikes as fairly tight. For this reason we would adopt a more tactical approach to perpetual CEFs. For example, last Friday we highlighted the Preferred & Income Securities Fund (JPS) which was trading at a 10% discount that has now compressed to 5.4%. Alternatively, for less tactical investors, we would wait out this relatively rich discount valuation period in either term CEFs like the Nuveen Preferred and Income 2022 Term Fund (JPT) or active ETFs like the First Trust Preferred Securities and Income ETF (FPE).
Now that the market appears to have calmed down somewhat from the fast and furious moves that we saw in March, investors may be considering their strategic allocations. An important choice for fund investors is whether to go with an ETF or a CEF in a particular sector. Our takeaways in this article are that first, the choice between the two types of funds depends in part on both market conditions and characteristics of a particular sector. And secondly, there is no “right” choice for all investors since investment styles can range widely. Using the preferreds sector as a case study we find that the underlying market is attractively priced, active funds have delivered excess returns and CEF discounts are on the rich side. For these reasons we would adopt either a tactical approach to perpetual preferreds CEFs or tilt to active ETFs or term CEFs.
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