Last week, we looked at a subset of pooled investment vehicles known as closed end funds. Those funds occupy a narrow space in the panoply of investments available to investors. Because they are somewhat more complex than their mutual fund brethren, greater diligence is required in evaluating their appropriateness.
One complicating factor in assaying a closed end fund’s potential is the use of leverage. According to the Investment Company Institute, 65 percent of all closed end funds employ the use of debt or derivative strategies to lever up exposure in search of amplified returns. Archimedes of Syracuse discovered the law of the lever describing how force is multiplied about a fulcrum. Likewise in finance, returns can be multiplied through the use of borrowing. Sounds great.
Photo — Please put this mug shot of Chris Hopkins of Barnett & Co. in our system to use every other Wednesday when it will run with his column.Unfortunately, losses are also multiplied (think Archimedes on a teeter totter). Potential investors should investigate the degree of leverage and its potential impact.
Data from the industry’s trade association provides a useful illustration. According to the Closed End Fund Association, municipal bond funds led the pack in terms of returns for the previous 12 months. The General and Insured municipal bond category gained 4.1 percent without leverage, while the levered version of the same fund returned 5.2 percent, a 25 percent improvement in investment return thanks to financial leverage.
On the other hand, high-yield funds reported losses for the previous year. Those are popular with income seekers thanks to their relatively generous cash flow yields, but have suffered from the use of borrowing as the value of the holdings declined. Leveraged high-yield CEFs lost 12.1 percent compared to the 10.2 percent loss in comparable unlevered funds. It is crucial to know how much leverage is being employed and to understand the potential impacts, both positive and negative.