Why are closed-end funds using leverage?

Introduction

A closed-end fund or "CEF" is one of the more popular types of investment funds in the U.S., along with mutual funds and exchange traded funds or "ETFs", as explained in our educational article investment fund types. There are currently 491 closed-end funds with a total market capitalization of $209,128,316,887.   See our list of closed-end funds. You can screen closed-end funds using our closed-end fund screener.

An important thing to understand about closed-end funds is that almost 2/3rds of all closed-end funds use leverage to magnify the returns of the common stockholders of the fund. One way that a closed-end fund uses leverage is by having the fund issue debt or preferred stock. This is referred to as "structural leverage". The amount of debt or preferred stock that a closed-end fund can issue is limited by the Investment Company Act of 1940 to a maximum of 50 percent and 33 1/3 percent of overall fund assets for preferred shares and debt, respectively.

So a closed-end fund with $50,000,000 in common stockholder's equity can issue preferred stock totally $50,000,000, bringing the fund's total assets to $100,000,000. Different people use different terms to describe how much leverage this represents. We use the term "leverage factor", which in this example would be 2.00 (because total assets are twice the amount of common stockholder's equity). But other people might refer to this as "50% leverage". There is also a lot of discussion of "asset coverage" - the fund in this example would have an asset coverage of 200%.

On a nightly basis, we calculate the leverage factor of every closed-end fund using the fund's most recent financial statements. Here is a summary of the current leverage factors of closed-end funds:

Leverage Factor RangeCount
1 to 1.5322
1.51 to 2.0167
2.5+2

Conceptually, does it make sense?

Closed-end funds are issuing preferred stock and/or borrowing money, in the hope that they can invest the borrowed money at a rate of return that is higher than their borrowing costs. Conceptually, that might make sense for a closed-end fund that is investing in publicly traded common stocks or making risky investments in private companies a la a venture capital firm. But does it make sense for a closed-end fund that invests primarily in municipal bonds or corporate bonds? It is not so clear to us.

Closed-end funds pursue all kinds of investment strategies, but there aren't a lot of closed-end funds the invest in equities (common stocks). Here is a summary of the closed-end funds by category:

Category1Fund CountMarket capitalization%
Alternatives28$14,563,237,4907%
Asset Allocation43$14,842,555,3237%
Commodities4$7,378,460,7804%
Global Equity44$16,384,563,7958%
Global Fixed Income 41$17,101,236,0918%
Special Security Types35$12,148,656,0556%
US Equity 53$31,418,841,73315%
US Fixed Income 243$95,290,765,62046%
Total491$209,128,316,887100%

Conceptually, the riskier the asset, the greater the long-term reward. Are these closed-end funds investing in assets that will return a reward that is greater than their cost of borrowing? Closed-end funds are borrowing money from banks or issuing notes that are probably considered to be "investment grade debt". Or they issue preferred stock. What asset classes should theoretically return more than investment grade corporate debt and preferred stock? Theoretically, high yield corporate debt or common stocks. But it seems to us that the margin of error can be pretty small.

What does it cost a closed-end fund to issue preferred stock? There are currently 32 publicly traded preferred stocks issued by closed-end funds. The average dividend yield on those stocks is currently 5.14%.

What does it cost a closed-end fund to issue debt? There are currently 2 publicly traded notes, or what we call exchange traded debt, issued by closed-end funds. The average dividend yield on those notes is currently 0.00%.

It could be that most closed-end funds can issue preferred stock or debt that is privately held at a lower cost than issuing publicly traded preferred stock or debt. So perhaps the average cost of the leverage used by closed-end funds is less than the examples we are providing by looking at publicly traded securities. But our point is that it seems like most closed-end funds won't make that much extra return for common shareholders if they are borrowing at 5.14% or 0.00% to invest in a portfolio of fixed income investments.

ETFs use leverage in a cheaper way

Leveraged exchange traded funds use a different type of leverage than a closed-end fund, since ETFs are not allowed to issue preferred stock or debt at a fund level. As explained in our article what is a leveraged ETF?, leveraged ETFs use derivative products such as swap agreements with large investment banks to achieve their leverage. It is unknown how much these swap agreements cost a leveraged ETF, because the cost of the swap agreement is hidden in the ETF's overall fee disclosures. But on average, leveraged ETFs have total expense ratios that are often less than 1%.

The fund's managers may have an incentive to use leverage

Some closed-end funds have fee agreements under which the manager is paid a fee based on assets under management. Normally, this makes sense, as the fund wants a manager who will make smart investment decisions, which will grow the fund's assets and attract new investors. But one side effect of such a fee arrangement is that managers are indirectly incentivized to use leverage, because by definition the issuance of debt and/or preferred stock will increase a fund's assets.

Conclusion

We are not making a blank statement that closed-end funds should not use structural leverage. Like always, investors need to understand what they are buying and understand the risks involved. Our overall suspicion is that the gains to most closed-end funds from using structural leverage are pretty small, as it is pretty hard to successfully borrow money and invest it for a return that is higher than your borrowing costs. It's pretty hard to tell from looking at the financial statements of a closed-end fund how much the leverage has added to the fund's net investment income. Some closed-end funds are good about explaining in their annual report or their semi-annual report whether the leverage has been effective or not. If you are looking for investment funds that are using leverage, you are probably better off looking at leveraged ETFs.


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