John Cole Scott, Chief Investment Officer at Closed-End Fund Advisors — Chairman of the Active Investment Company Alliance — continues The NAVigator’s ongoing effort to answer audience questions, this week digging into nuts-and-bolts issues like how to find the best closed-end fund in any sector, how to judge if a fund might reduce its distribution or change its term date, and how to size up expense ratios and yields to make sure you are accurately judging costs and returns.
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CHUCK JAFFE: You’ve got questions, we’ve got answers from John Cole Scott at Closed-End Fund Advisors, welcome to a closed-end fund Q&A on The NAVigator. This is The NAVigator, where we talk about all-weather active investing and plotting a course to financial success using closed-end funds. The NAVigator is brought to you by the Active Investment Company Alliance, a unique industry organization representing all facets of the closed-end fund industry, from sponsors and creators down to users and investors. If you’re looking for excellence beyond indexing, The NAVigator will point you in the right direction. Returning to the show today, John Cole Scott, president of Closed-End Fund Advisors in Richmond, Virginia, online at CEFAdvisors.com. Their data, which is really important to almost everything John talks about because it backstops all of his work, is available for you free, and you can dig into it for yourself at CEFData.com. And beyond his firm, John is the chairman of the Active Investment Company Alliance, so you can go there to learn all about closed-end funds, interval funds, and business-development companies at AICAlliance.org. We’re digging into some questions that have come in for The NAVigator, and before we start I’ll remind you, you can submit questions to us at TheNAVigator@AICAlliance.org. John Cole Scott, welcome back. Great to chat with you again.
JOHN COLE SCOTT: Happy to be here, Chuck.
CHUCK JAFFE: So today we are doing some nuts and bolts questions about closed-end funds, or at least they feel a little nuts and bolts to us, some may be a little simple for our audience but not necessarily all. Let’s start with one that kind of digs into research in its own way, which is, “How do I find the best closed-end fund in each sector?”
JOHN COLE SCOTT: Well, you know, that’s the easy question, right, Chuck? What’s going to happen next in capital markets, interest rates, recession, global politics? And so what I’ll say is the layers of analysis that we do at the firm for our clients, and remember we’re long only, we don’t hedge, we’re pro-closed-end funds, we obviously like them, we eat them for breakfast, but we look at a couple things. We look at discounts as a factor, we look at quality of management and NAV, we look at what’s in the portfolio, so if there’s 10 funds in a sector, is one more global, one more US? Is one more debt, one more equity? There’s a lot of balance and hybrid structures in our universe. We also look at the expense ratio, it’s never the most important but you should analyze it because it’s part of the math of what NAV will do, and we really look at things like volatility, so we look at the two-year weekly beta of the NAV versus S&P 500, and also its benchmark. That gives us a sense of is this fund’s manager – this is not discount analysis, this is manager analysis – a more volatile manager or less? And there are times, and there are clients, where we lean into the more volatile, and there are times where we lean to the less volatile. We also do a silly thing with dividends, we look at the one-year classification for a portfolio in each fund and look at its breakup historically, one-year, two-year, three-year, how common is return of capital, qualified dividends, long-term gains, which are all the tax advantages, and how common is ordinary income and short-term gains? And we try to understand in your marginal tax bracket, what’s your after-tax yield, what’s your tax friction, our benchmark is your qualified rate, should generally be the rate the portfolio level should give you. So the answer is not simple, name brand fund, widest discount, highest yield, as you might imagine, there’s layers. Now if I roll it back a little bit and an individual investor that may be retired, so has time but doesn’t have our 335 data points daily at their analysis, you need to look at the fund’s fact card, the fund sponsor to know what you’re in, and then the discount sadly is the most important thing because tight discounts tend to widen, wide discounts tend to narrow, but like we talk about regularly, diversify your portfolio, not one sponsor, not one sector, rarely be over 5% in one holding, and you should be okay, but there’s levels of what you can look into to pick that fund for you. Now imagine, you can always tax-loss swap the right time of year, you can rotate based on what happens next with interest rates and GDP and other factors as well.
CHUCK JAFFE: John, this one is a common one because everybody’s looking at closed-end funds because they like the yield, which is, “Do you think my closed-end fund’s going to reduce my distribution? How can I tell that one’s coming? What are the trouble signs?”
JOHN COLE SCOTT: So couple things. First, analyze the sector the fund is anchoring in, whether it’s a muni bond fund or a CLO fund, very different return and yield profiles. We use a data point that we like to call leverage-adjusted NAV yield to consider what the manager has to do to meet the dividend policy of the board and how reasonable that feels in the real world environment. We also look one-year, three-year destructive return on capital, never a perfect data point, but is the NAV performance fueling the NAV yield, and is there return on capital? Helps us figure out whether the return on capital could be considered destructive to principal. When we regularly find people who think all return on capital is bad, or some people think all return on capital is good, it’s definitely not that answer. And so the other flavor is activism and discounts, if the fund is trading wide there’s less risk to a cut because they don’t want to trade wider, activists can come in and they usually will raise distributions as a way of getting more cash out closer to NAV, which is what an over-distribution is. And then secondly, just remember in a terrible market event you can put a lot of stuff in the news cycle and not get penalized for it, so if things get crazy, that could be the cut. So if it’s normal, less likely, remember if it’s reasonable, you can be overpaid and it’s still fine the wider the discount is versus history and the peer group.
CHUCK JAFFE: Let’s do a related question. “Could my term closed-end fund change its term date?”
JOHN COLE SCOTT: Great question. The term structure is also known, well, not only, but the recent ones are the CEF 2.0 structure, been around for a while, they basically came in and send generally after 12 years you can get net asset value. If enough people vote to stay, the fund will become, what’s left, a permanent vehicle. Here the question comes, is it an asset manager where are they willing to do a semi-terrible thing just to keep a fund a little longer? This came up when one of our data clients asked about the relatively soon term trust for Blackstone senior loan funds, where when they were at premiums they actually extended the term because the whole market was doing well and shareholders voted to extend the term. That’s great. Currently it wasn’t at a premium, in my opinion they’re going to probably unwind those funds, Blackstone is doing many other things, their manager’s reputation is important. The risk would be one-off or if in the future an IPO is unlikely, still probably not going to happen, but if you’re thinking of the tail risk, the manager doesn’t care. If he’s not likely to ever bring another closed-end fund to market, through the IPO market, they’re not going to worry about hurting peoples’ experience. Because at the end of the day, these fund sponsors, when the market comes back, which it always has, the wholesalers will be going to advisors and they’re going to have to explain the good, the bad, and the ugly, so it’s always a possibility, but generally shouldn’t be considered a major risk in the market in our experience.
CHUCK JAFFE: And lastly we’ll dig into a real nuts and bolts question about expenses, which is, “Are closed-end fund expense ratios included in the yield? So if a closed-end fund has an expense ratio of 2% and a yield of 10%, is the yield really 10% or is it 8%? And then with fees and other expenses, if a fund states that it has a 2% expense ratio but it uses leverage, are the leverage fees included in the expense ratio or are they on top of it?”
JOHN COLE SCOTT: So the general expense ratio you’ll see on a fact card at a Morningstar are going to be operational expenses, management fee, and cost of leverage, it’s an all-in cost. When you look at the distribution rate of a closed-end fund, it is not taking into account management fees or operating expenses. I can’t think of a fund where this isn’t true, but every fund we know of, they accrue their expenses daily in NAV. So it’s like you never see the movement, it’s just at the end of a year you’ve paid the, let’s say it’s all-in 2% with leverage, non-gross, non-leverage or whatever, so it’s not yield-centric, it’s just the manager is getting its fees out of the NAV. Now if the NAV does terribly, there’s less investments to produce yield, but the yield is the either manufactured distribution set by the board based on long-term performance or it’s in many cases fueled mostly from real earned income or distributions for many of the bond funds.
CHUCK JAFFE: And of course funds have a responsibility to basically pay out, what is it, 98-99% of the income that they bring in because they’re a pass-through vehicle.
JOHN COLE SCOTT: They are. If they don’t pay out enough of it they have to pay excise tax, which it has happened once or twice in BDCs that didn’t like how they were trading. I’ve never noticed it happen in a closed-end fund and it would be considered silly because you would trade terribly and then you’d be hearing from Karpus and Bulldog, Saba and Sit, in my experience.
CHUCK JAFFE: Yeah. So the answer is consider the fees and expenses in a closed-end fund the same way you would with your traditional mutual funds, which is they’re not getting in the way when you see a fund doing something and performance is stated there, the fees are factored in and the performance is what the performance is.
JOHN COLE SCOTT: It is.
CHUCK JAFFE: John, great stuff as always. We’ve got more questions and we’re again hoping we’ll get some more still, TheNAVigator@AICAlliance.org is the place to send them, but until those next questions or we have another conversation, thanks as always for joining me on The NAVigator.
JOHN COLE SCOTT: Always enjoy chatting, Chuck.
CHUCK JAFFE: The NAVigator is a joint production of the Active Investment Company Alliance and Money Life with Chuck Jaffe, and I am Chuck Jaffe, and you can learn more about me and my show at MoneyLifeShow.com, you can find my show on your favorite podcast app. To learn more about closed-end funds, interval funds, and business-development companies generally, go to AICAlliance.org, that’s the website for the Active Investment Company Alliance. Thanks to my guest John Cole Scott, he’s president of Closed-End Fund Advisors, he’s the chairman of the Active Investment Company Alliance. His firm is online at CEFAdvisors.com and you can dig into their data at CEFData.com, and John’s X @JohnColeScott. The NAVigator podcast is available every Friday, make sure you don’t miss an episode by following or subscribing on your favorite podcast app. We’ll be back next week with more closed-end fund talk, and until then, happy investing, everybody.
Recorded on April 4th, 2025
