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Closed-end funds, commonly referred to as CEFs, are popular investments for income-focused investors, especially retirees. There are many good reasons for this, which we will discuss in this article. However, it is important for investors to be particularly careful about investing in closed-end stocks The financing space in the current environment. In this article we will discuss why.
Advantages of investing in closed-end funds
First, mutual funds are well diversified, typically holding dozens if not hundreds of individual positions, which reduces the risk incurred by any single company in its portfolio. Second, they are often actively managed, meaning they can adapt their holdings and strategies to changes in macroeconomic conditions, rather than sticking to a passively managed algorithm.
Third, they trade just like stocks, and are therefore completely uncorrelated with the net asset value of their underlying assets, unlike ETFs, which They always trade with very tight spreads compared to their net asset value. As a result, investors can often purchase mutual funds at a significant discount to the value of their underlying portfolio, thus effectively purchasing stocks at a discount.
Another major advantage of mutual funds for income-focused investors is that they often pay very high distribution yields, including in many cases on a monthly basis. This is less common with ETFs, which tend to pay lower returns and only on a quarterly basis. Although some funds like the JPMorgan Equity Premium Income ETF (JEPI) and the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) have changed that by paying high returns and diversifying well.
However, the difference between ETFs like JEPI and CEFs is that JEPI generates this high return from using a hypothetical covered call strategy, where premiums from hypothetical covered calls fund the distribution, thus defining the upside during a bull market. In contrast, mutual funds often support their high returns by using leverage in their portfolios and investing borrowed money in higher-yielding securities. The difference between high-yield securities and the margin interest they pay enables them to boost their returns. In addition, some mutual funds pay out more than they generate in internal earnings by liquidating some of their capital gains over time.
Regardless, between leverage and enhanced returns, these mutual funds can be powerful income generators, and are also likely to provide great total returns during a bull market. Many investors also reduce the risks posed by high returns and relatively high leverage by diversifying across several mutual funds, believing that if one or two of their funds cut their dividends, the diversified nature of their mutual fund portfolio will help mitigate… The fluctuations to which their investments are exposed. Income and its basic principles.
Why mutual funds are risky investments right now
However, CEFs also come with increased risks at this time. First of all, the leveraged nature of mutual funds makes them highly risky. In addition to the high cost of leverage in the current high interest rate environment, the use of marginal leverage significantly increases the risk of long-term compounding. As Warren Buffett once warned:
There are only three ways a smart person can go bankrupt: liquor, ladies, and leverage.
Furthermore, he warned that:
You really don’t need influence in this world that much; If you are smart, you will make a lot of money without borrowing.
The reason leverage is so dangerous, especially marginal leverage, is that as Warren Buffett shared again with shareholders of Berkshire Hathaway (BRK.A, BRK.B) in his 2019 shareholder letter:
When it comes to margin debt, even if your loans are small and your positions are not immediately threatened by a market downturn, your mind may be rattled by scary headlines and breathless commentary, and an unsettled mind will not make good decisions.
Furthermore, anything can happen at any time when investing. As he also said in the same letter:
There is simply no telling how far stocks can fall in a short period. Over the past 53 years, the company has built value by reinvesting its dividends and letting compound interest work its magic. But at any time, the light can go from green to red without stopping at yellow.
In fact, Berkshire Hathaway has seen its stock decline five times in its history. Between 1973 and 1975, Berkshire shares collapsed 59%. In 1987, it fell by 37%. Between 1998 and 2000, it decreased by 49%. Between 2008 and 2009, it fell by a whopping 51%, and in the 2020 Covid crash, it fell by 26%. Suppose Berkshire shareholders used a large margin of leverage during any of those collapses. In this case, they may have faced margin calls, and the powerful, long-term compounding machine that Berkshire has been for many decades would likely be interrupted, as they may have had to sell some or even all of their shares to cover those margin calls. , sustain those losses permanently and thus lose at least some, if not all, of the subsequent uptrend.
It is for this very reason that mutual funds are very risky. In fact, we learned this the hard way during the market crash of 2020. We invested heavily in the now-defunct Nuveen Energy MLP Total Return CEF, because it traded at a significant discount to NAV and provided a leveraged exposure to some of the leading and stronger companies In MLPs such as Enterprise Products Partners (EPD), Energy Transfer (ET), and MPLX (MPLX). However, because it had a leverage ratio of 30% at the time, which unsurprisingly resulted in a significant increase in its dividend yield, it was very vulnerable to the massive collapse that rocked the energy sector during the coronavirus outbreak. As a result, the fund was actually forced to close and liquidate itself due to its margin debt, and investors suffered huge losses.
Keep in mind that this can happen at any time to any leveraged fund due to a black swan event or even due to such a shock event not occurring. If you look at the current environment we find ourselves in, you will find that there are many risks that appear to be very high and could cause chaos in the markets if they occur. For example, recent economic data increasingly point to the possibility of an economic slowdown in the near future. Manufacturing activity contracted for the second month in a row, and the Federal Reserve Bank of Atlanta’s GDP model recently cut its second-quarter growth forecast from 2.7% to a strikingly low 1.8% due to weak data from the Institute for Supply Management and the Census Bureau. Unemployment continues to rise and is approaching 4%.
Meanwhile, consumer spending is also falling, with disposable personal income falling 0.1% in April for the second time in three months. In addition, the personal savings rate fell to 3.6%, its lowest level since December 2022, and consumer savings accumulated during the coronavirus have now been fully spent.
Moreover, geopolitical risks are sky-high, with increasingly hostile rhetoric between China and its neighbors, especially Taiwan, and the United States. Fears about the continuation of the Russian-Ukrainian war and the possibility of its expansion to other parts of Europe, and the continued escalation of the war in the Middle East and the possibility of its expansion as well. In addition, oil inventories around the world are increasing, with OPEC announcing an increase in oil production, and copper inventories swelling on the Shanghai Stock Exchange, indicating a slowdown in the Chinese economy, which is the largest consumer and buyer of copper in the world. Of course, the yield curve remains sharply inverted, which is also an indicator of recession.
Finally, monetary policy also looks like it will remain a headwind, as the Fed must balance its fight against persistent inflation with trying not to keep interest rates too high. However, the Fed has erred in keeping interest rates higher for longer, which poses a threat to stock valuations as well as underlying business fundamentals. Meanwhile, the bond market continues to bet on a recession, with the yield curve remaining inverted and 10-year Treasury rates falling.
Finally, the stock market remains highly overvalued based on many leading indicators. This means that if geopolitical and/or macroeconomic risks turn into actual headwinds, the market could see a significant decline or even collapse. As a result, highly leveraged mutual funds pose a particular risk in the current environment. For example, the investor-favorite PIMCO Dynamic Income Fund (PDI) is considered risky in our view because it trades at a large premium to its net asset value, is highly leveraged, has a high expense ratio, and invests in low-quality loans. .
As a result, if the market and the economy collapse along with it, PDI would likely see not only its NAV and thus its stock price decline, but its stock price would decline even further due to the large premium to its NAV at the moment. In addition, its dividend is likely to be reduced as its underlying assets face an increasing number of defaults.
Furthermore, other mutual funds we like so much, like the Cohen & Steers Quality Income Realty Fund (RQI), the Cohen & Steers Infrastructure Fund (UTF), and the Reaves Utility Income Trust (UTG) are likely to suffer as well as they don’t… None of them have much of a margin of safety in their NAV price right now. They all have a high amount of leverage and do not have full coverage, if any, of their underlying earnings from internally generated cash flows. As a result, if another market crash occurs, and especially if a severe economic downturn is the catalyst, we would not be surprised if all of these central financial markets see significant price declines and perhaps even some earnings cuts.
Investor takeaways
While mutual funds are powerful passive income vehicles that can make passive income retirement simpler for retirees, they are still risky investments, especially because of their high leverage in the current environment. Any one of a number of potential catalysts could occur to push the economy and market sharply lower. CEFs could take a severe hit as a result. Retirees who depend on them for passive income should diversify their holdings into other positions that are more likely to sustain their payments through such a scenario.
One excellent and simple option for those who don’t need such high returns is the Schwab US Dividend Equity ETF (SCHD). However, for those who want higher returns, we build a diversified portfolio of high-quality, high-yielding individual stocks. One of our current favorite picks is Enterprise Products Partners (EPD), as it is very likely to be able to maintain its distribution during downturns. For those who don’t like K-1, we think Enbridge (ENB) is one of many suitable alternatives.
