What Is The Cash Flow Problem For Open-End Mutual Funds?
Summary
We discuss the advantages of the CEF structure vs the traditional Open End Mutual Fund.
Most investors have never heard of a closed-end fund ("CEF") however most know even the basics about open-end mutual funds. There are many key similarities but there are some small structural differences that can provide a few KEY advantages to CEFs.
The primary one is the CASH FLOW PROBLEM of the open-end mutual fund. They are called open-end because they allow daily subscriptions (purchases) and redemptions (sales). In other words, at 3:59pm EST, I can enter a sell order for all my shares of a mutual fund I own and I would still get that days price on my sale.
The problem is that the portfolio manager of an open-end fund has to contend with DAILY cash flows into and out of their fund. A former portfolio manager friend of mine who ran a larger high yield bond mutual fund used to say that investors would pull money every day the market was down and add money on up days, without fail. All those inflows and outflows create a performance drag on the fund.
That problem does not exist in a closed-end fund. By definition, the fund is closed meaning no new cash is accepted. [There are some funds that are raising new capital through share issuance but that is the minority]. This is especially beneficial today as interest rates have plummeted.
New investors into large open-end bond mutual funds get the ability to piggyback older investors producing some additional yield above current rates. Think about this example: I launch a mutual fund in 2007 with $1M in assets. The assets yield 6.5% which is about where BBB- rated investment grade debt traded at the time. Three years later, interest rates plummet to near zero and money flows into fixed income. Tons of new capital flows into my fund ballooning the assets to $4M. The new rate of interest is 3.5%- still higher than the current rates at the time but far less than what it was trading before.
What happened? The older investors (those that made up the original $1M, got diluted away and the new money (the additional $3M) was invested at the then, current and much lower rates. The old assets weren't sold or matured, but they became a very small portion of the portfolio.
Again, in a CEF, there is no "cash flow problem", inherent in both exchange traded funds ("ETFs") and open-end mutual funds. The ability to buy and sell daily in these open structures makes for an extremely inefficient wrapper, especially on the bond side. The ability for the portfolio manager to avoid forced-selling in down markets (due to redemption requests) means that they could take advantage of the higher yields in illiquid bonds and hold them to maturity.
Here's a great example of the difference that the cash flow problem can cause. The turnover ratio for a traditional total bond fund solution is typically in the hundreds of percent. As an example, PIMCO Income Fund (PONAX) has a turnover ratio of 472%. Fidelity Total Bond (FEPIX) has turnover of 170%! That means that Fidelity Total Bond bought and sold 170% of the current assets of the fund over the course of the year.
We can compare that to another bond fund like Blackrock Credit Allocation (BTZ) which has just 30% turnover. Or better yet, PIMCO Dynamic Income (PDI) which reports just 12% turnover.
That turnover can be a significant drag on performance. The cash flow problem is one few investors know about. I'll use munis as another example. A year ago, open-end muni funds provided a yield of 2.60%-3.00%, depending on the strategy. As rates fell, NAVs of muni funds went up. Fund flows were significantly positive as new investors rushed in. But that money needs to be invested at CURRENT rates which were coming down hard over this summer. That capital deployment then dilutes the existing shareholders and reduces the yield for everybody.
In summary, we think investors who have sizable dividend portfolios and need assistance in reducing risk and reliance on those sources of income, could utilize CEFs to their advantage. The conundrum investors face in regards to their lack of yield on their bonds can be solved, you just need to know where to look. We think we can continue to earn a 7%+ yield without reaching substantially down the risk spectrum. While we will have some non-investment grade and other risk assets in our portfolio, it will be paired with relatively safer assets, like munis.
Our marketplace service, Yield Hunting, is comprised of multiple models that can be followed by members:
YH Core Income Portfolio : Current yield approx. 7% - this is a buy and hold style of portfolio made up primarily of bond CEFs which produces realized income every month.
YH Flexible Income Portfolio : Current yield approx. 8% - this portfolio of CEFs is more tactical attempting to achieve higher TOTAL RETURNS (Combination of realized income and capital gains).
YH Taxable Core Portfolio : Current yield approx. 6% (~60% being tax-free) - this is a portfolio for high income earners to reduce tax drag comprised primarily of muni CEFs.
YH Managed Portfolios: Broken up into Conservative, Moderate, and Aggressive, these are managed model portfolios to follow for those who need a bit more hand holding.
YH Safe Bucket Portfolio : Current yield approx. 3.5% - this portfolio is for your "cash plus" money that is meant to be protected from equity and bond risks.
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