Should You Investment 100% of Your Retirement in Closed-End Funds?
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 517. It's titled, Should You Invest 100% of Your Retirement in Closed-End Funds? Recently on the Money for the Rest of Us Plus forums, we got into this discussion of whether we should invest our entire retirement portfolio in closed-end funds.

closed-end funds. Plus Membership is our premium membership community. We have the forum. We have a weekly Q&A plus episode, audio episode. There's video lessons. There's a closed-end fund course on there. I began investing in closed-end funds back in 1994 and became much more active in doing so during the great financial crisis. My approach to closed-end fund investing has generally been opportunistic.

more of a trading strategy. I'll start screening for closed-end funds when the overall financial markets are falling because that's when they get cheaper. The discount relative to the net asset value widens out. I'll explain what that means in more detail in a few minutes. But that's not the only way to invest in closed-end funds. We'll take a look at two other approaches.

in this episode. But first, let's discuss what a closed-end fund is. A closed-end fund is a type of mutual fund where investors pool their money and a professional money management team oversees the portfolio by selecting underlying stocks, bonds, and other securities. These are very old vehicles. The first closed-end fund was launched in the late 1700s in the Netherlands.

The first ones in the U.S. were launched in the late 19th century. This investment vehicle, closed-end funds, is older than open-end mutual funds and definitely older than ETFs. But it's very much a niche strategy. There are only about 400 closed-end funds in the U.S., about $250 billion in assets. So each fund's relatively small, about $500 to $600 million in assets on average. That compares to...

over 7,000 open-end mutual funds with over $20 trillion in assets and more than 4,000 ETFs with over $10 trillion in assets. And the number of closed-end funds in the U.S. is shrinking. The number has fallen every year for 12 consecutive years, down upwards of 40%.

in terms of the number since 2011. Why are closed-end funds shrinking? Well, they are an inferior investment vehicle relative to ETFs. And so there's been mergers in the closed-end fund space. Let's take a look at the differences between ETFs

an open-end mutual fund and a closed-end fund, an exchange-traded fund. A closed-end fund you can buy in the secondary market on an exchange, so it trades throughout the day in the same way an exchange-traded fund does, whereas an open-end mutual fund only trades at the end of the day. A closed-end fund has a fixed number of shares, and so there is not an ongoing share creation process as you see with open-end mutual funds and

and ETFs. The only way additional shares are outstanding in the closed-end funds is they do a follow-up offering, a rights offering to allow existing shareholders to buy additional shares and new shareholders to buy shares. But there's a structured process. It's not an ongoing, it's a new securities offering, essentially. With an open-end mutual fund,

They trade at the end of the day and the market price that it's traded at equals the net asset values. They're connected. They're equal. Whereas with a closed-end fund and an ETF, as they trade throughout the day, there can be a disconnect between the market price and the net asset value.

The net asset value, it's calculated by taking the value of a fund's assets or an ETF's assets, including cash, subtracting out any debt there might be and dividing by the number of shares. And so it's the value of the holdings on a per share basis. And then since an ETF and a closed-end fund trades, the market price can disconnect from the net asset value.

Now, with closed-end funds, that's by design. There isn't a mechanism to narrow that discount, whereas ETFs were designed with a mechanism, active participation of authorized participants and market makers to keep the market price in line with the net asset value. So they're trading the shares of the ETFs, they're trading the underlying holdings of

of the ETFs. And ETFs have done a very good job of keeping the premium or discount of the price relative to the net asset value very close. Whereas with a closed-end fund, these discounts or premiums can last for years. And that's a feature, a benefit, if you're trading and you want to buy a closed-end fund at a

a discount, 80 cents on the dollar. You're getting more assets per dollar when a closed-end fund sells at a discount. Closed-end funds traditionally have focused on generating income. And so about 60% of closed-end funds are fixed income investments. 40% are stock funds, but even the stock funds are trying to generate a high dividends, high distribution. Sometimes they'll do that through what

what's known as a managed distribution strategy, where they try to keep the dividend or the distribution the same each month, which means sometimes they're paying out income. Sometimes it could be a return of capital. Let's say it's a stock closed-end fund. It might have unrealized gains. It doesn't want to sell those, but it's appreciated, and it could distribute some of those unrealized gains as return returns.

of capital to the shareholders as part of a managed distribution strategy to keep the dividends high, the distribution high. And many closed-end funds have distribution rates of 7%, 8%, 9%, 10% on partly its

Because one of the other characteristics of closed-end funds is they use leverage. And so the closed-end fund will go out and borrow money, or they might issue preferred stock in order to lever up the portfolio to generate more income, a higher distribution.

Now, some ETFs use leverage, some mutual funds use leverage, but it's pretty common in the closed-end fund space to have 20, 30, or 40% leverage. And they can do that because you can't liquidate your holding in a closed-end fund. You can't go to the sponsor and redeem shares like you can with a mutual fund or if you're an authorized participant with an ETF. With a closed-end fund,

That's permanent capital, which has allowed closed-end funds to invest in less liquid asset classes to lever up the portfolio because they don't have to worry about investors pulling money from the closed-end fund. If investors want to get out, they'll sell their shares in the secondary market, and that could widen the discount. So that is an inherent advantage of

of closed-end funds, permanent capital, ability to use leverage to generate a high income that can manage the distribution. But when we compare closed-end funds to ETFs, because of the mechanism that ETFs use to keep the market price in line with the net asset value, we won't get into the details of that mechanism. We've done it in other episodes.

And there's a lesson on it on Money for the Rest of Us Plus on how ETFs work. But it's very tax efficient because they can pass off low cost basis holdings to the authorized participants. And then the shareholders of the ETF, they don't have to be subject to those potential gains. And so ETFs are much more tax efficient than closed end funds. I mentioned the closed end funds tend to be smaller. So 75% of closed end funds have

less than $600 million in assets. And that allows these closed-end funds to be more nimble, to get into less liquid securities. And the small size of closed-end funds makes it difficult for institutional investors to invest in them, to get positions, although that has changed. There are a number of hedge funds that are actively involved in closed-end funds, including activist hedge funds like Saba Capital that

that purchase shares of the closed-end funds, they start working with the board to try to get the board, even to get a board seat or to get the closed-end fund to take action to narrow a persistent discount to net asset value. So you're seeing much more activists investing in the closed-end fund space, and that is leading to more mergers within clients

closed-end funds, which is why the number of closed-end funds outstanding are dropping. And the reality is ETFs are just a better vehicle in many regards. And certainly the fees are much, much lower expense ratios with ETFs than they are with closed-end funds. And partly it's because closed-end funds have a smaller capital base. They can't create unlimited number of shares or create shares as easily as an ETF can.

So what are some strategies if one was considering investing their entire retirement in closed-end funds? What are ways to do that? There are two books that are referred to. One called Income Factory by Stephen Bavaria came out in 2020. The other book, Capitalism.

Came out in 2023. It's titled Retirement Money Secrets by Stephen Selingut. He's a former financial advisor. Stephen Bavaria has written for years on seeking alpha, but his approach is called an income factory. It's a buy and hold approach. The idea is to build a diversified mix of closed-end funds that have attractive distribution yields and then just ride them out.

whether they sell at a premium discount, you just generally hold them. And the idea is not to spend all the distribution, but to reinvest it in compounds so that your capital grows and you're able to grow the distribution or income you're receiving over time. He points out in his book that, think about Ford producing cars, the market value of the plant isn't as important

as other factors when it comes to Ford producing cars. They care about producing income. And in the same way, owning stocks, bonds, and the

the underlying securities of a closed-end fund, it's to generate cash flow. Again, closed-end funds primarily are income-focused. He writes, the income factory that produces that river of cash obviously has a very real economic value to us, but the price the market attaches to the income factory from day to day or even month to month is largely irrelevant to us as long-term investors. And

And so this buy and hold approach doesn't spend time thinking about the pricing, whether a closed-end fund is selling at a discount or a premium. Now, you might consider that when purchasing a new one, but generally the idea is to build out a diversified portfolio of closed-end funds and hold them. Before we continue, let me pause and share some words from this week's sponsors.

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With Steve Selingut's approach, he calls his an income-focused retirement investing, IFRI.

He focuses on two things. One is the base income. What are the dividends and the interest and other payouts or distributions you're getting from the closed-end fund? And his rule is to only spend 70% of those distributions and reinvest 30%. And so both the income factory and the income-focused retirement investing approach of Selengad is...

You don't spend all of the cash flow you're receiving. You're reinvesting a large percentage of that in order to build out a bigger portfolio. Now, where Salingut differs is he also focuses on what he calls working capital. And that's the total of all the money you've paid to purchase the closed-end funds, plus any cash. Now, again, he doesn't care about the market value. He's focused on the cost basis.

What was paid? And that's an accounting measure.

He wants to know what the yield cost is. What's the distribution rate relative to the cost of what was paid? Which distributions from income turn a capital you're getting relative to the cost? I struggled with that concept because I tend to focus much more on what is it worth? What is the market value? Is it selling at a premium, which means I should probably reduce my holding, my allocation, or is it a discount?

But in his case, he cares about what the distribution is, spend only 70% of it. But what is the cost? The other thing is much more active in trading. So the approach is to sell closed-end funds that have had a 5% appreciation. So if it goes up 5%, he'll sell and go find another closed-end fund to buy, irrespective of whether it's

It's selling at a discount or a premium. It's just an automatic rule. Now, there's some caveats to that in his book, but generally that's the rule. And here's the thing that I really struggled with. Because of the focuses on the cost basis, if one had a closed-end fund and had purchased it at different times and it appreciated 5%, he's selling or recommends selling the tax lot

that has the lowest cost basis. In other words, the one that would generate the greatest capital gain. And his thought is, well, if your boss offers you a $10,000 a year raise, you don't turn it down because you'll have to pay more in taxes. And I've said similar things that paying taxes is part of being a successful investor. It means you made money, but that doesn't mean you go out of the way to try to maximize your tax payments, which traditionally

trying to find the closed-end fund in your portfolio with the lowest cost basis, that just was not intuitive to me. But that's the approach. And the approach is to ignore pricing other than did it go up 5% more than what you paid? That's the rule. One of the concepts in closed-end fund investing is what's known as the Z-score. And it's a statistical measure

comparing whether the premium or the discount is greater than average. Is it greater than the average discount over the past five years? And it's one of the main trading rules that I teach on Money for the Rest of Us Plus in the closed-end fund course. It's how I analyze closed-end funds, screen them, decide what to buy, what to sell. But

Selengat doesn't care. He writes, I could care less if its current price is above or below its normal relationship to net asset value. He says, I've never felt the need to know his E-score. So it is a different approach. It's focused on what did you pay? Did it go up 5% and then sell? And a key aspect is heavily diversified. Both approaches are diversified among a number of

of closed-end funds, and they both focus on reinvesting, not spending all the distribution to live on in retirement or even if you're not in retirement, but reinvest a big component. Now, you can do that also with ETFs or other strategies, a reinvestment, but given closed-end funds pay out such high distribution rates, they're reinvesting a meaningful percentage of that, and I think that's a good thing.

Now, the other thing that I found odd about Selengut's approach is he doesn't care about the fees either. Close-end funds have higher than average expense ratios compared to ETFs. They're actively managed. They're smaller pools. And so there's the management fee that goes to the fund manager. There's other fund expenses. And then because they use leverage, there's the interest expense.

Selling gut rights, it's a misconception that shareholders pay any of the expenses listed for closed-end funds. And by that, he means the closed-end fund isn't knocking on the door asking for fees. It's not like paying a financial advisor, but it is an expense of the income factory. If the fees weren't quite as high, let's say the management fee, then the closed-end fund could pay out more in income, a higher distribution. So I found that odd. I think

It's important to look at the fees. And when I'm analyzing closed-end funds and we discussed it in our course, we're making sure what are the fees. And I care about the pricing. Is it at a discount or a premium? And a closed-end fund that I sold last month, late last month, was Bering Corporate Investors Fund, MCI. I mentioned this earlier this year in January in our discussion of private credit. This is a closed-end fund that invests in...

It essentially lends to middle market companies. It's very involved in that lending and helping to manage those companies, providing guidance. It's a way to invest in private credit, as we discussed in that episode. Well, I purchased this back in March, 2022. It hit my screens. The ticker's MCI was selling at a 12% discount to net asset value. And I've kept it almost three years. But then this year, it moved to a venture.

Very large premium. Last summer, it was still selling at a discount, but by mid-February, the premium had soared to over 30%. Now, at the beginning of the year, it had moved to a 15% premium, but as I mentioned, I think in this episode is MCI only releases its net asset value on a quarterly basis as it does appraisals of the underlying debt that it holds, but still a 36% premium soared

started to make me nervous. And so I sold it. And one reason, because they don't announce their net asset value, but once a quarter, I knew they would be releasing that in late February. And because interest rates had risen since they last released their net asset value, which was as of September 30th, 2012,

At that time, it was $17.20. I thought that there was a good chance that the new net asset value would be lower. And it was. They came in when they released it. The year-end net asset value that was released in late February was $16.84. So down 2% from the previous one.

And then since then, the closed-end fund continues to sell at a premium, but it's down meaningfully its market price from where it was trading back in mid to late February when I sold. Now, this is a closed-end fund that the return was 29% annualized over my holding period. Now, if I could do that with all the closed-end funds, that'd be great, but that isn't

realistic. This worked out really well. I bought it at a discount. I sold at a premium. Typically, I would not have held on that long, but it's not a pure buy and hold strategy.

Would I invest 100% of my retirement in closed-end funds? No. The main advantage of a closed-end funds is their ability to lever up the portfolio. But even there, there's some judgment. If I looked at the annual report of some of BlackRock's closed-end funds, some that invest in the senior loan space or the bank loan space. So the BlackRock Debt Strategy Fund, DSU, is one I've held in the past.

bought at a discount, the discount narrowed, and then I sold. Well, if you look at the cost of the underlying debt that they used to lever the portfolio, last year it averaged 6.1%. And then it's investing in bank loans that are yielding 7% to 8%. So even though the portfolio is levered up, right now with the Federal Reserve's policy rate really high, the cost of debt for closed-end funds is much higher, which

reduces the amount of money they have to pay distribution. So the debt cost makes a difference. Oftentimes, closed-end funds will issue preferred stock. And I own some preferred stock from a couple of Gabelli closed-end funds, and their dividend is 5%, 5.2%, based on the net asset value. And so that's the cost of debt. And so, yeah, the leverage is there, and that can be beneficial, be additive to return. But...

There are times when the leverage has a bigger impact based on what interest rates you're doing. The other reason I wouldn't necessarily, or the main reason I wouldn't put all my investments in a closed-end fund, it's just a lot of work. It requires the same decisions that you would require if you weren't investing in closed-end funds. What should the asset allocation be? How much in stocks? How much in bonds? You have to be reinvesting these dividends all the time.

Sellingut says that he never travels on the days that he gets the dividends so he can reinvest them quickly. You have to choose your asset allocation, decide which closed-end funds to be in. A lot of them are different asset classes. You have to learn about preferred stock, about collateralized loan obligations. So many more asset classes that these closed-end funds hold. And that takes monitoring and it takes work. And maybe you're up to it, but would your spouse be up to it?

if you're no longer able to do that. Figuring out what to buy, what to sell. And so that's why my preference has been to do it, invest in closed-end funds more opportunistically and to be aware of price. Even if I was investing my retirement, I wouldn't ignore the prices of closed-end funds. I would monitor if they were selling at a premium and pair back and add when selling at a discount. But that also takes monitoring and more work

I didn't really agree with Selling Guts' approach of focusing on cost and ignoring fees and ignoring discounts and premiums and Z-scores and just selling when it appreciated 5% and not being terribly tax conscious, just figuring that's part of investing, paying capital gains. That's just not how I approach investing. But it was an interesting book, interesting approach, professionalism.

I prefer Stephen Boveria's approach. I think it's a better book. Learn some things from it. But ultimately, I wouldn't put 100% on my retirement in closed-end funds. And I prefer a more opportunistic trading approach to closed-end funds. And that's what we've taught on Money for the Restless Plus, including in our course. So that's episode 517. Thanks for listening.

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