The past couple of years have served as a stark reminder to investors that volatility strikes (often quickly and unexpectedly). In March 2020, when the Covid-19 pandemic really took hold in the US, the CBOE Volatility Index (VIX), which reflects market uncertainty and fear, hit its highest level in nine years.
Despite important strides in economic recovery, supply-chain disruptions from global Covid-19 lockdowns persisted into the beginning of this year, leaving lingering inflationary pressures in their wake.
And then, to complicate the investment landscape further, Russia invaded Ukraine earlier this year, to great humanitarian and economic impact. The West responded with economic sanctions that have exacerbated the ongoing supply-chain issues.
The result? Anxious investors, volatility and market sell-offs. But in times of uncertainty, we believe that closed-end funds (CEFs) could be an attractive choice versus their open-end peers.
Market sell-offs: CEFs vs. open-end funds
When open-end funds experience a sell-off, their managers must sell assets quickly in order to raise cash to meet redemptions. CEFs, on the other hand, operate on a fixed pool of capital. Trades in the secondary market fulfill redemptions; that is, the managers are not required to raise any cash from the portfolio.
It’s important to note that CEF investors are still able to redeem their holdings, as they would with a listed operating company like Amazon or Alphabet. The difference is that CEF managers are able to look through marketplace short-term noise and potentially take advantage volatile markets. A CEF manager can consider whether or not it’s an appropriate time to sell assets, independent of any investor redemptions.
Advantages of CEFs in an age of volatility
CEFs also offer access to defensive asset classes. There are plenty of CEFs investing in defensive areas with low correlations to equities, such as infrastructure. Private assets can also dampen NAV volatility. Private assets can be attractive diversifiers when markets fall rapidly because they are not marked to market on a daily basis. Therefore fundamentals — not sentiment — drive their valuation.
CEF shares are bought and sold on the secondary market, so supply and demand drive their prices. These shares may trade above their net asset value (at a premium) or below (at a discount). During the most significant market sell-offs in the past two years, CEFs have sold off alongside equities, which we feel presents a buying opportunity to investors.
CEF share prices aren’t immune to market sell-offs. But during these periods, the discounts for CEFs tend to widen. Buying a fund at a historically wide discount provides another source of return for investors.
If markets continue to fall throughout this year, which we view as a distinct possibility, compelling opportunities to buy closed-end funds at a discount could present themselves.
Investors must bear in mind, however, that discounts are not guaranteed — buying at a premium is also a possibility.
Chart 1: All CEFs — 20-year discount history
Source: CEFdata.com, June 2022
However, investors should not focus on discount alone. Fundamentals, including investment manager philosophy and track record, along with the outlook for the underlying asset classes, should come first. And, above all, investors must consider how a fund fits in with their broader portfolios.
CEFs — and, more broadly, active management — may present a compelling opportunity for investors seeking to weather market storms. Unlike with passive funds, active managers have the flexibility to react thoughtfully to events that shake up markets, like the war in Ukraine.
Active managers are able to follow an investment process that buys high-quality companies with strong balance sheets and an ability to cover their dividends. Passive investments, on the other hand, are bound by the indices they track. Before making any decisions, investors must consider their individual investment needs, but we believe that CEFs may be an attractive opportunity when confronting market volatility.
Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund’s investment return and principal value will fluctuate so that an investor’s shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund’s portfolio. There is no assurance that the Fund will achieve its investment objective. Past performance does not guarantee future results.
The use of leverage will also increase market exposure and magnify risk.
Closed-end funds are similar to mutual funds and exchange-traded funds (ETFs) in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds and ETFs, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Open-end funds can be bought or sold at the end of each trading day at their net asset values (NAVs). Because closed-end funds and ETFs trade throughout the day on an exchange, the supply and demand for the shares determine their market price; closed-end funds’ and ETFs’ market prices may fluctuate through the trading day and those prices may be higher or lower than their NAVs. Closed-end funds, mutual funds and ETFs charge investors annual fees and expenses. All of these products may use leverage to enhance their returns, which can magnify a fund’s gains as well as its losses. Closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. All three vehicles seek to deliver returns based on their investment objectives, but none of them are FDIC insured. The Revenue Act of 1936 established guidelines for the taxation of funds, while the Investment Company Act of 1940 governs their structure. abrdn does not provide tax or legal advice; please consult your tax and/or legal advisor.
Any individual companies or other securities discussed above have been selected for illustrative purposes only to demonstrate abrdn's views or investment management style. They're not meant as an investment recommendation, indication of future performance or as an indication of any holdings by abrdn.