Closed-end confusion

It wasn’t very long ago that closed-end funds were popular choices for income investors. But with the surge of ETFs (exchange-traded funds), their closed-end cousins have been almost forgotten.

Both types of funds trade on stock exchanges but that is about all they have in common. Closed-end funds are so named because, at least in theory, there are only a limited number of shares in circulation. An initial public offering of, say, 10 million shares at $10 each would raise $100 million which, after commissions were paid, would be invested in an actively-managed portfolio. The value of the shares would rise and fall depending on the performance of the investments.

In the case of popular, well-performing funds, the managers would sometimes issue additional shares from their Treasury, offering current unitholders the right of first refusal. However, this practice has the effect of diluting the original shares and, as a result, was never popular.

Because of the limited number of closed-end fund shares in circulation, the market value can be very different from the portfolio’s net asset value (NAV), with the units often trading at a discount, sometimes a substantial one. Newer funds have tried to mitigate this problem by offering an annual redemption privilege at NAV but even in these cases a small discount usually applies.

ETFs, like mutual funds, are open-ended. There is no limit on the number of shares in circulation. When demand increases for units of an ETF, Designated Brokers (DBs) have the ability to create additional units through a complex “in kind” transfer mechanism. As a result, ETFs normally (but not always) trade at close to their NAV.

The decline in public awareness of closed-end funds has resulted in some modest bargains. One example is the Blue Ribbon Income Fund (TSX: RBN.UN) which I recommended last February in my Income Investor newsletter at $11.12. It closed on Dec. 16 at $10.57, which is a discount of 3 per cent from its most recent NAV of $10.89. The fund is managed by Paul Bloom, one of Canada’s leading experts in high-income securities. The portfolio is mainly composed of REITs, current and former income trusts, and limited partnerships. The fund pays monthly distributions of $0.055 ($0.66 a year) which works out to a projected yield of 6.2 per cent based on the recent trading price. I still rate it as a Buy.

Another closed-end fund that is on the Income Investor list is the Aston Hill VIP Fund (TSX: VIP.UN), which we originally recommended as the Brompton Tracker Fund in mid-2005. It has gone through a number of iterations since and ownership recently passed from Brompton to Aston Hill Financial.

This fund was savaged in the market meltdown of 2008-09 but has been gradually recovering under the direction of Alan Wicks of Manulife Asset Management. The mandate is to invest in a portfolio of high-quality, income-generating securities, using a bottom-up stock selection approach. Top holdings include Shoppers Drug, Power Corporation, Canadian Tire, Berkshire Hathaway, and BCE, so this fund has a much different feel than the Blue Ribbon Fund.

This fund pays monthly distributions of $0.07 a unit ($0.84 annualized), most of which is tax-advantaged, either as return of capital or dividend income. Based on the Dec. 16 closing price of $8.52, that works out to a 9.9 per cent yield which appears to be unsustainable in the current market climate without eroding NAV ($8.91 per unit at the time of writing). So investors should expect either a distribution cut in the New Year or to see the price of the units gradually decline unless there is a strong recovery in the stock market. As a result, we advised selling in a recent issue of the newsletter.

As you can see from these two examples, you have to be very careful in selecting a closed-end fund. Don’t be mesmerized by a high yield; if it is not sustainable the value of your asset will gradually wither away. And take a close look at the fund’s trading history in relation to NAV. If it tends to trade at a discount, see what the range has been and try to buy in when it is at a periodic low.

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