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Closed-end funds (CEFs) are a “hidden gem” among investment vehicles for retirees and other long-term investors looking for yield and monthly distributions. CEFs do this because of unique features granted by the Investment Company Act of 1940. Unfortunately, the law unintentionally contains a loophole providing institutional investors an advantage over individual investors that some are using to the detriment of the CEFs and their retail investors.
I hope, having invested in CEFs for years, and having written extensively about CEFs and their importance in a capitalist system of ensuring legal and economic rules apply equally to everyone, that we can bring this to the attention of the SEC and Congress.
Let’s get it fixed.
The loophole allows hedge funds and other institutional CEF investors, seeking to achieve short-term benefits at the expense of long-term retail shareholders, to skirt the 1940 Act’s 3% ownership limit by combining theoretically “separate” but commonly controlled owners to accumulate larger voting blocs than the law intended. After buying large blocks of a CEF’s shares at a discount to the fund’s net asset value (NAV), these “activists” attempt to force a liquidity event at NAV to realize a short-term profit. The more 3% entities an activist has, the larger the voting block, and the more likely the fund relents and performs the liquidity act. This shrinks or eliminates the fund and limits the monthly payouts that individual investors value in a CEF.
This is all detrimental to the interests of the fund and its longer-term shareholders.
I have no objection to shareholders proposing actions they feel are in the best interests of all equity owners, as long as they operate within the limits of the 1940 Act and make their case to existing holders of the fund. But they should not be allowed to engage in purely short-term tactics, like seeking to install a new ownership group as a bloc, just for the purpose of forcing a shareholder vote, with little concern for the fund’s or its shareholders’ longer-term interests.
For example, in May 2020, Bulldog Investors took action against the Western Asset Variable Rate Strategic Fund (GFY). In order to force the fund to offer a large tender, Bulldog refused to approve a new investment management agreement with new owner Franklin Templeton Investments. GFY, realizing how small and uneconomic the fund would become if it acceded to Bulldog’s demands, decided to fully liquidate. Ultimately, the outcome benefitted Bulldog, which had purchased its stake through several different corporate vehicles, but at the expense of small shareholders who lost a source of monthly distributions that some had relied upon for over 15 years.
What makes CEFs so valuable to individual investors? They are “closed-end” rather than “open-end” like most mutual funds. This virtually eliminates the “run on the fund” risk faced by traditional funds whose investors can redeem shares on a daily basis, sometimes forcing funds to dump their most attractive assets at the worst possible time. Avoiding this risk allows CEFs to access less liquid and more complex asset classes (including preferred stocks, covered-call equity strategies, convertible bonds, syndicated loans, high-yield bonds, collateralized loan obligations, and private equity) in actively managed vehicles available to retail investors. Meanwhile, CEF managers can invest 100% of their funds’ assets without the earnings drag of maintaining a cash cushion for possible redemptions.
CEFs have features that boost the yield to the funds’ investors beyond the “natural” yield of the assets held in the fund. Since their shares are traded on the open market, just like other equities, patient investors can often buy CEFs at a discount to the net asset value of their underlying holdings. This means you have more assets “working for you” than you actually paid for. For example, a CEF whose assets yield 6% of their face value would be paying you 6.7% if you bought its shares at a 10% discount.
CEFs also give retail investors an opportunity to access cheap institutionally priced leverage that is otherwise unavailable. Typical CEFs can borrow up to 50% of their total assets from lenders and/or by issuing preferred shares. If the CEF in the above example borrowed 35% of the amount of its assets at an interest cost 5% lower than the 6.7% it was earning (due to the discount) on its portfolio, that additional 5% spread on 35% of its assets, minus a typical fund management fee, would add about another 1.9% to the yield available to the CEF’s shareholders, increasing it to about 8.6%
These advantages – unlocking attractive asset classes to retail investors, discounts that allow investors to have more assets “working” for them than they paid for, and the ability to boost yields with institutionally-priced leverage – mean an increase in retirement income to CEF investors when compounded over many years.
Hedge funds and other institutional investors that engage in short-term tactics are aggressively using the 1940 Act loophole to target CEFs, threatening the future of the funds and the security of the millions of investors who rely on them for regular distributions. By thwarting the spirit of the law to accumulate oversized positions and forcing the funds to either fight them off or fully or partially liquidate, they are weakening (even destroying) many funds and injuring the CEF industry in general. It is long-term individual investors who will suffer from this and bear its ultimate cost.
The SEC and Congress must address the issue before more of our nation’s retirees and Main Street investors are deprived of this uniquely vital investment vehicle.
Steven Bavaria is the author of The Income Factory: An Investor’s Guide to Consistent Lifetime Returns. His earlier book, Too Greedy for Adam Smith, focuses on the need to ensure that the same rules apply to all in a capitalist society, including those at the top of the socio-economic pyramid. He was formerly an executive at Standard & Poor’s and Bank of Boston, and was a reporter and editor covering the credit and financial markets at Investment Dealers’ Digest. He is a graduate of Georgetown University and New England School of Law.
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