I recently got some reader feedback that made me realize something: When it comes to our favorite income investments—8%+ yielding closed-end funds (CEFs)—there are still a lot of misconceptions out there.
It’s key that we put those right, because they’re causing some investors to miss out on CEFs, and the big (and often monthly) dividends they provide. And I know I don’t have to tell you that in turbulent times like these, high payouts like those are a lifesaver.
This reader wrote in response to a recent piece I wrote about how CEFs can be better than ETFs, pointing out two things:
- The three CEFs I mentioned in the piece have higher expense ratios than passive funds.
- There are cheaper ways to buy stocks that the CEFs I wrote about in that article own (more on them below), such as Microsoft (MSFT), a major holding of all three of these CEFs.
Let’s address both of these concerns because they are valid—and both are often cited by financial advisors and the mainstream media as reasons to avoid CEFs and invest in ETFs, like the SPDR S&P 500 ETF Trust (SPY).
Following that advice can cost you significant dividends: CEFs currently yield 8.5% on average, while SPY, the largest ETF by market cap, yields a paltry 1.4%.
So, let’s dig into the first issue.
Closed-End Funds Have Higher Fees … Right?
I am not going to disagree with the feedback here, because it is true.
On average, CEFs have management fees of 2.9%, which sounds very high compared to what you’d pay on the average index fund.
I should note before we go further, though, that the two CEFs we’ll get into below (both of which appeared in the article)—the Virtus Artificial Intelligence & Technology Opportunities Fund (AIO) and the Columbia Seligman Premium Technology Growth Fund (STK)—charge much less: about 2.7% for AIO and 1.1% for STK.
The fees for the BlackRock Science and Technology Trust (BST), the other fund mentioned in that article, are about the same as STK, at 1.09%, but we’re going to focus more on the other two funds, and the opportunity we have in them, today.
Here’s where our reader picked up on a common misunderstanding about CEF fees, suggesting that these fees are taken out of the income and total returns these funds provide. In other words, if the fee were to be taken out of AIO’s dividend, its 7.8% yield would actually amount to 5.1%, net of fees.
But this isn’t how CEF fees work.
Let’s take the most important detail first: The fees that CEFs charge are taken out of the fund’s portfolio before distributing dividends. The fund will not remove it from the yield you receive: If AIO yields 7.8%, that means you will get $780 a year for every $10,000 you invest. The fees are taken care of on the back end, before AIO reports its capital gains and pays out distributions, so all the profits I’m about to show you are net of fees.
Are the fees justified? In my opinion, getting $78,000 on a million-dollar nest egg is worth it, since the low-fee alternative offers $14,000 in dividends on that same million bucks.
Also, I should point out that those CEF fees tend to remain as low as possible because of competition. The fees that CEFs charge are a combination of administrative fees, payment to fund managers (which is often the smallest part of the fund’s assets, typically around 0.07%), and payment for things like leverage costs (both of these funds typically borrow money to fund investments, and AIO is currently borrowing more than STK, which is why its fees are higher).
In the end, though, this one chart is why I think the fees are justified, even without accounting for these funds’ much higher yields.
Both AIO (in blue) and STK (in purple) have outperformed the S&P 500 since AIO’s inception (it was released in late 2019, which is why this chart goes only that far). And STK’s outperformance goes back much further.
Now, to be sure, these funds are weighted toward tech, but it is also worth pointing out that the S&P 500 has been increasingly weighted to tech stocks (now about 45% of the index), which explains some of the outperformance here.
But with fees as “high” as the ones they’re charging, you’d expect SPY to be more competitive (again net of fees).
To be sure, the SPY shareholder paid less in fees. But the SPY shareholder also missed out on $1.137 of profits for every dollar they would have put into STK when it launched.
Cheaper Ways to Buy Stocks?
The second criticism also has some merit, although maybe not in the way the reader meant. Let me explain.
Both of these funds have a fixed number of shares they issue to the general public (this is fixed at the IPO). This is why the fund is called a closed end fund. While those shares trade on exchanges, like any stock, the issuer can’t issue new shares to grow the fund.
The price of a share of a CEF will fluctuate according to supply and demand, which means its market price can drift up or down from the liquidation value of all of its assets on the open market, which is called the net asset value, or NAV.
Above you can see AIO is trading at a 6.5% premium to NAV as I write this, while STK’s 1.5% premium is smaller than the 10%+ premiums it’s had in the past, and is pretty close to trading at par.
So, yes, you can get Microsoft cheaper than you can by buying it with AIO (by the way, MSFT is 3.24% of AIO’s portfolio, its second-largest position). How? By buying STK!
But of course, these are still both premiums. Lucky for us, we can do even better, by purchasing a heavily discounted CEF like the 9.4%-yielding Liberty All-Star Growth Fund (ASG), a recommendation of my CEF Insider service trading at a 7.9% discount to NAV, with Microsoft as its top position, at 4% of assets, followed by NVIDIA (NVDA) at 3.3%.
And check this out.
See how ASG (in blue) is at that 7.9% discount as of this writing, while AIO (in purple) is at a 6.5% premium, but in 2020, ASG traded at a premium and AIO traded at a discount?
If you’re thinking there’s an opportunity here to buy ASG when it’s discounted, sell when it’s at a premium, then buy AIO when it’s at a discount and do the opposite trade when AIO swings to a premium, you’re right. This isn’t just what some niche hedge funds do. It’s also the kind of move we’re always looking to make at CEF Insider.
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report “Indestructible Income: 5 Bargain Funds with Steady 8.6% Dividends.”
Disclosure: none
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