When the Closed-End Fund Pricing Mechanism Blows Up

In January 2018 we wrote... "Savvy investors may see opportunity in CEFs trading at a discount to NAV but should also consider that the CEF pricing mechanism adds an additional layer of volatility to their investments. Such additional volatility reduces risk-adjusted returns. The Nasdaq HANDLS indexing solution addresses this drawback by providing exposure only to ETFs that allow for creations and redemptions, which reduces the risk that the market price of an ETF share will deviate from its NAV.”

For years investors have relied upon closed-end funds (CEFs) to access leveraged-income strategies and high managed-distribution policies. As of March 31, 2020, CEFs held approximately $276 billion in assets under management across 494 funds. Another billion dollars or so of assets under management sit in exchange-traded funds (ETFs) that invest in CEFs.

Like ETFs, CEFs issue shares that trade on an exchange. Unlike ETFs, CEFs offer no means for market makers to create or redeem shares to ensure that they trade at approximately the same price as their net asset value (NAV). Consequently, CEFs may trade at market prices that differ significantly from their underlying NAVs. While some CEFs trade at a premium to their NAV, most tend to trade at a discount to NAV.

Of critical importance to investors is that a CEF’s discount (or premium) to NAV fluctuates over time, meaning investors experience additional volatility from the CEF pricing mechanism that is incremental to the volatility of the CEF’s underlying portfolio. During good times characterized by relatively liquid markets, CEF premium-discount volatility may be muted. But during times of stress, CEF discounts to NAV can widen dramatically as investors scramble for liquidity.

March of 2020 was a month to remember, one that saw most income-oriented asset categories first destroyed, followed by a Federal Reserve-driven recovery that began in the usual places—mortgage-backed securities, investment grade credits, municipal bonds—and ended in April (for now) with the country’s national bank dipping its toe in the high yield bond market for the first time ever. Among the largest losses for income investors—and many CEF funds—came from high-dividend equities, many of which will be paying lower or no dividends for the foreseeable future.

As would be expected, the NAVs of CEFs tracked the performance of their underlying holdings in March, first declining across the board, with recoveries led by the NAVs of CEFs that invest in higher-grade asset classes. On top of this underlying portfolio volatility, the market for CEF shares went haywire, culminating in a panic from March 18^th through March 20^th that saw indiscriminate selling and the widest discounts to NAV for CEFs since the Great Financial Crisis.

The largest ETF of CEFs, the Invesco CEF Income Composite ETF (PCEF), saw the average discount to NAV of the CEFs in its portfolio fall to -21.9% compared to a 52-week high of -3.1%. Even the largest and most liquid CEFs struggled to find bids as margin calls and liquidity needs drove forced selling. To illustrate the extent of the carnage, we constructed a basket of 18 of the largest and most liquid taxable fixed-income and equity CEFs[1] and averaged their daily discounts/premiums to NAV going back to the beginning of 2018.

For most of the period covered by the graph above, this basket of large CEFs traded at a modest discount to NAV, with some widening during the market downturn that occurred in late 2018. By the middle of 2019, with markets in a strong upward trend, the basket started to trade at a slight premium to NAV and remained at a premium until February 2020, when the first cracks in the markets began to form. By March, markets were in a free fall, and on March 18, 2020, the basket traded at nearly a -20% discount to NAV.

Relief for the CEF market came first in the form of a statement from the Federal Reserve on Friday, March 20 that it would begin purchasing municipal bonds, a popular asset category for CEFs. The following Monday the Federal Reserve announced it was launching two credit facilities to support the primary and secondary investment-grade corporate bond markets. These actions, combined with the Federal Reserve’s prior move to backstop the mortgage-backed securities market, served to put a floor under CEF market prices and led to an end-of-month rally that pushed the average discount to NAV for our basket of large CEFs to about where it started at the beginning of March. Had you gone to sleep at the beginning of March and woken up at the end, you might think nothing much had happened in the CEF market other than steep NAV declines in CEFs with a greater focus on lower-grade asset classes.

While the first CEFs came along some 30 years before the first open-end mutual fund, mutual funds nevertheless quickly overtook CEFs as the preferred structure for pooled investments and hold about 70 times more assets today. Proponents of CEFs defend the structure as a superior way to hold illiquid investments and use more leverage than mutual funds or ETFs can legally employ under the Investment Company Act of 1940.

While both defenses have some merit, the vast majority of CEFs invest in relatively liquid securities and employ levels of leverage that would be permissible for mutual funds and ETFs. There is no reason these strategies could not be executed as either mutual funds or ETFs, reducing volatility associated with premium/discount movement. With that in mind, we created the Nasdaq 7HANDL Index (7HANDL Index) with the objective of offering investors access to a leveraged income strategy that eliminates the drawbacks of the CEF structure, including its pricing mechanism.

By employing a well-diversified, multi-asset portfolio of low-cost ETFs, the 7HANDL Index seeks to employ diversification to minimize idiosyncratic risk posed by particular asset classes and individual securities. By reducing or eliminating such idiosyncratic risk, diversified portfolios can earn higher risk-adjusted returns than undiversified portfolios. The use of low-cost ETFs reduces embedded fund costs to levels significantly below those of CEFs while minimizing the potential for the market values of the index’s constituents to vary dramatically from their NAVs.

To illustrate how the 7HANDL Index performed during the recent market downturn, we compared its performance going back to the beginning of 2018 with the performance of the S-Networks Composite Closed-End Fund Index (the CEF Index)[2], a leading index of CEFs. The graph below looks at how $10,000 would have grown tracking each of the 7HANDL Index and CEF Index from January 2018 through March 27, 2020. Inset in the graph is a smaller graph illustrating the total return performance of each index for the month of March 2020.

For most of the period, the two indexes performed in line with each other, although the CEF index did underperform during the market downturn in late 2018 as the average discount to NAV temporarily widened across the board. The fortunes of the two indexes changed dramatically, though, when March of 2020 rolled around. While both experienced losses, the breakdown of the CEF pricing mechanism caused the CEF Index to lose 34% from March 1 through March 18, roughly 22 percentage points worse than the performance of the 7HANDL Index over the same time period. And while the CEF Index recovered toward the end of March, it still ended up returning -17.44% for the month compared to -6.30% for the 7HANDL Index. The table below provides performance data for both indexes for the period from January 1, 2018 through March 31, 2020.