Closed End Bond Funds are Like a Legalized Ponzi SchemeJuly 16th, 2012 by Marc Prosser
Every so often, the topic of closed end bond funds will come up in a discussion. Someone will mention that they have found a fund with a consistent high yield. However, with closed end funds yield may be very misleading.
What are Closed End Bond Funds (CEF)?
Just like an exchange traded fund, closed end bond funds trade on the market like a stock. They have a market price that can be above or below the value of their assets (also referred to as Net asset value or NAV for short). However, there are several big differences between exchange traded funds (ETFs) and closed end bond funds (CEFs):
- The number of shares of an ETF available for trading is dynamic. A closed end bond fund has a fixed number of shares that does not change. When the price of an ETF is below the value of its underlying assets (NAV), there is a natural process which results in the reduction of the number of shares of the ETF available for trading (you can learn more about this on our Bond ETFs page. Conversely, more shares are created when the price is above its NAV. This generally results in the price of the ETF in the market and its NAV staying within a few percent of each other. Closed end bond funds do not have this mechanism, and therefore often trade at a 5 to 20% discount or premium to their NAV.
- ETFs cannot increase their leverage by borrowing money. Closed end bond funds frequently borrow money to increase their leverage.
- ETFs payout all income and capital gains they generate, no more and no less. Closed end bond funds can pay more or less than the income and capital gains they generate.
What is the attraction of closed end bond funds?
There are three arguments that are used to promote closed end bond funds:
1) Closed end fund Managers are better positioned to focus on the long term than a typical mutual fund manager. When money is leaving a mutual fund (en masse), a fund manager must sell assets to raise cash. As a result, mutual fund managers tend to avoid assets that are not very liquid, even if non-liquid assets are better investment opportunities.
If many clients withdraw funds from a closed end bond fund, the value of the fund’s shares will drop, however the fund manager is not forced to sell assets. This means that closed end funds can more easily buy less liquid assets and focus on the long-term.
Our problem with this thinking: I am not 100% convinced that less liquid assets provide better investing opportunities. There have been a number of studies indicating that funds which invest in non-liquid assets generally do not do better than those investing in the liquid assets.
2) Leverage provides an opportunity for greater profit. If you like a type of investment or manger, why wouldn’t you want to give the manager a chance to make more money by borrowing?
Our problem with this thinking: Leverage means more risk as well.
3) The biggest advantage the people cite is the consistent, high monthly distribution payments. The problem with this advantage is that these payments are often derived using smoke and mirrors.
Here is why this can be little more than a legalized Ponzi Scheme
Many well known closed end funds like the PIMCO High Income fund, pay high consistent dividend payments. Every month like clockwork, PIMCO delivers a distribution of 12.19 cents per share. If you are living on a fixed budget, knowing the amount that you will receive each month is very attractive. With most bond ETFs and bond mutual funds, the amount varies each month, making budgeting difficult.
One would assume that these distributions come from interest income or investment gains. WRONG! Often times the fund has been selling assets (reducing the fund’s NAV) to provide these dividends, basically using a portion of the money invested in the fund to pay out the dividend. This is one of the major reasons why the NAV for the PIMCO High Income Fund is around half of the initial share price of the fund. As more of the fund’s assets are depleted, it has to use more of its assets to pay distributions, creating a vicious cycle. Basically, this is what happened with Bernie Madoff. The difference is that Madoff hid the fact that he was using investor’s capital to pay distributions, claiming it was profits. This story does not end well for investors either way.
More Reasons Why We Don’t Like Closed End Bond Funds
- High Annual Expense Ratios
- High Cost Of Exiting A Position. The bid/ask spread, the difference between the price which you can sell and buy a closed end fund is very high compared to ETFs or stocks. If you were to buy a fund and then immediately sell it, you would typically lose half to a full percent.
Big Surprise! Closed End Bond Funds Aren’t That Popular
The three biggest closed end municipal bond funds are all run by Nuveen Investments: Nuveeen Municipal Value (NUV), Nuveen Municipal Opportunity (NIO), and Nuveen Premium Income Muni 2 (NPM). Collectively there is less than $5 billion invested in these funds.
The three biggest taxable closed end bond funds are run by three different firms: AllianceBernstein, Aberdeen, and Eaton Vance. Collectively, there is less than $7 billion in these funds.
The top three taxable bond and municipal bond closed end funds together have less than $12 billion dollars in investments. This is less than 1/20th of the amount the top bond mutual fund (Pimco Total Return fund) has. The market has made its decision. Closed end funds are not very attractive.