In a recent episode of “The Insurance Pro Blog Podcast,” we explored an often-overlooked investment vehicle that could revolutionize retirement planning: closed-end funds. My guest, Steve Selengut, shared his expertise on how these funds can be used to create additional income streams in retirement. Let’s take a closer look at the key takeaways from this informative discussion.
Understanding Closed-End Funds
Closed-end funds have been around since the early 19th century, predating mutual funds and ETFs. Despite their long history, they are less well-known than their investment counterparts.
What are closed-end funds?
Closed-end funds are investment vehicles that:
- Are structured as trusts, rather than unit ownership like mutual funds
- Trade on exchanges, similar to stocks
- Let prices be determined by supply and demand, not net asset value (NAV)
- Are legally required to distribute 95% of their earnings to shareholders
This last point is especially important for income-oriented investors. Due to the high distribution requirements, closed-end funds are designed more for steady income than for significant capital appreciation.
How closed-end funds differ from mutual funds and ETFs
Unlike mutual funds and ETFs, closed-end funds offer:
Do not issue or redeem shares daily to achieve net asset value.
Can trade at prices above or below their NAV.
Frequently use leverage to increase returns.
The return potential of closed-end funds
One of the most attractive aspects of closed-end funds for retirees is their high return potential. According to Selengut, many closed-end funds currently offer returns of around 10 percent—significantly higher than traditional fixed-income investments.
Return Comparison: Closed-End Funds vs. Traditional Investments
To put this into perspective, consider a $1 million portfolio:
- Traditional 4% withdrawal rule: $40,000 annual income
- 10% return from closed-end funds: $100,000 annual income
This significant difference in income potential makes closed-end funds an attractive option for those looking to maximize their retirement income. And you can generate enough income through distributions (monthly or quarterly) to avoid selling stocks to achieve your income goals.
Leverage in Closed-End Funds: Understanding the Risks and Benefits
One aspect of closed-end funds that often raises concerns is the use of leverage. However, Selengut argues that this leverage is not inherently riskier than other forms of investment financing.
How Leverage Works in Closed-End Funds
Closed-end fund managers borrow money at lower interest rates to invest in higher-yielding securities. This strategy aims to increase returns for investors. Key points regarding leverage in closed-end funds include:
- It is typically limited to 50% of net asset value.
- Many funds use leverage of around 30%.
- Loans are typically short-term and at fixed interest rates.
- Some funds use preferred stocks for long-term loans.
Comparing Leverage with Other Investment Strategies
Selengut points out that leverage is standard in many investment areas:
- Real estate developers use debt to finance projects
- Companies issue bonds to finance their operations
- Even individual investors may use home equity loans to invest
The key is that fund managers only use leverage when they believe the potential returns exceed the costs.
Income-Oriented Investment Strategy for Retirement
A key theme of the discussion was the importance of focusing on income rather than just saving money when planning for retirement. This approach can lead to a more predictable and sustainable retirement income.
The Two Income Sources of Closed-End Funds
Selengut highlighted two main ways closed-end funds can generate income:
- Regular Distributions: Monthly or quarterly payouts from the fund’s earnings
- Profit-Taking: Selling fund shares for their value to realize capital gains
The Profit-Taking Strategy
Selengut advocates active management of closed-end fund portfolios, including regular profit-taking. This strategy involves:
- Setting profit target levels for each fund
- Selling when these targets are met
Reinvesting profits in other funds, potentially with better returns
This approach can potentially increase the portfolio’s overall return capacity over time.
Market Volatility: Friend or Foe?
Interestingly, Selengut argues that investors in closed-end funds can benefit from market volatility. This perspective refutes the common belief that volatility is always negative for retirees.
How Income Investors Can Benefit from Volatility
During Market Downturns:
Fund prices could decline, offering buying opportunities at higher returns
Investors can reinvest distributions at potentially better rates
The income stream from funds typically remains stable, even when prices fluctuate
This income stability, coupled with the opportunity to buy at better returns, can make closed-end funds an attractive option for retirement planning.
Practical Considerations for Investing in Closed-End Funds
Although closed-end funds offer significant potential benefits, several practical considerations must be taken into account when incorporating them into a retirement strategy.
Diversification and Risk Management
Selengut emphasizes the importance of diversification when investing in closed-end funds:
His portfolios typically include hundreds of different funds
This broad diversification helps reduce the risk of individual funds underperforming.
Avoid Automatic Reinvestment
Contrary to common practice with other investments, Selengut advises against automatically reinvesting distributions from closed-end funds. The reasons for this are:
- Better control over diversification
- Ability to seek new opportunities with distributions
- Avoid potential reductions in returns by reinvesting at higher prices
The Importance of Active Management
Successful investments in closed-end funds require more active management than a typical buy-and-hold strategy. This includes:
- Regular monitoring of fund performance
- Taking profits when targets are reached
- Reinvesting in funds with better returns or better value
Challenges and Considerations
Although closed-end funds offer significant potential for retirement planning, it is important to consider some challenges and potential drawbacks.
Complexity and Learning Curve
Investing in closed-end funds can be more complex than traditional mutual funds or ETFs. It requires:
- Understanding how closed-end funds work
- Regular monitoring and management of the portfolio
- A willingness to actively buy and sell based on fund performance and market conditions
Limited Popularity and Availability
Despite their long history, closed-end funds are less popular than other investment vehicles. This can lead to:
- Less readily available information and research
- Potential liquidity issues with some smaller funds
- Limited options with some 401(k) or other employer-sponsored retirement plans
The Need for Professional Advice
Given the complexity of closed-end fund investments, many investors can benefit from professional advice. This may include:
- Working with a financial advisor experienced in closed-end funds
- Using resources such as Selengut’s coaching services or investment newsletters
- Regularly receiving continuing education and information on market conditions and fund performance
Conclusion: A Powerful Tool for Retirement Income
Closed-end funds represent a potentially effective tool for generating retirement income. Their high return potential, coupled with active management and profit-taking strategies, can offer retirees a way to potentially increase their income beyond what traditional investment approaches suggest.
However, it is important to approach investing in closed-end funds clearly and understand the potential benefits and complexities. As with any investment strategy, it is advisable to conduct thorough research and seek professional advice, if necessary, before making any significant changes to your retirement portfolio.
By focusing on income generation and employing strategies like those developed by Steve Selengut, retirees may be able to create more stable and sustainable income streams to fund their retirement lifestyle. While closed-end funds are not suitable for everyone, they certainly deserve consideration as part of a comprehensive retirement strategy.
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