Consider closed-end funds to generate income

Income-seeking clients may be suited to closed-end funds (CEFs), which can provide lower-risk cash flow.

That may sound odd, as CEFs tend to be viewed as high risk. The perception’s based on the fact they aren’t subject to as many restrictions as open-end mutual funds. CEF managers have considerable leeway to use leverage and derivatives; they can also have more concentrated positions than open-end managers.

But not all CEFs are high-risk. Andrew Hamlin and Vivian Lo, portfolio managers at Aston Hill Asset Management in Toronto, run an income-oriented CEF with a focus on Canadian dividend stocks and U.S. high-yield bonds.

(in comparison, S&P/TSX is 8/10)

As the market cycle changes, they shift between management styles. Says Hamlin: “If you’re a value investor and we’re at the top of the market, there’s nothing you can buy because everything appears expensive. But there are opportunities; you just have to change your thinking.”

They’ve analyzed how equity market and economic cycles overlap, and determined which sectors tend to perform best at each stage (see “Cycles and sectors,” below). That knowledge guides their security selection.

“Currently, we’re in the recovery mode of the economic cycle,” says Lo, “so we’re looking at consumer discretionary, industrials and financials.”

Regardless of where we are in the cycle, Hamlin and Lo buy companies with strong fundamentals and the ability to generate cash flow.

Questions she and Hamlin ask when screening picks include:

• What is your sales growth?
• What acquisition opportunities do you have?
• Have you consolidated or merged with another firm in your industry?
• How much leverage is on your balance sheet?
• When was the last time you paid dividends?
• What secular tailwinds are you benefiting from?
• What challenges and opportunities exist in your competitive landscape?

Dividends vary by sector, Hamlin notes. “Companies in mature sectors like telecom or real estate are going to distribute a lot more to shareholders than industrials or consumer companies. But that’s fine, because [the latter] may be spending the rest to grow their businesses. We own some equities with a 4.5% yield, while others offer 0.80%.”

For fixed income, Hamlin and Lo are completely in U.S. high-yield, and they use the same process as they do for equities. Their bonds are across the ratings spectrum, with “B” as the average. The average yield is between 8% and 8.5%.

FUND Stats

Hamlin and Lo’s fund:

• must have no more than 30% high-yield;
• can have no more than 10% foreign and non-dividend-paying equities (combined); and
• can use leverage of up to approximately 20%.

It could work for clients who:

• want a predictable monthly income stream; and
• are content with medum to high single-digit returns.

Some companies are so good it makes sense to own both sides of the balance sheet. One example is Enova International, which provides online financial services to borrowers who can’t get traditional loans. “We owned the publicly traded debt, which paid out a cash coupon of 9.75% while the company was part of Cash America,” Lo explains, adding, “Enova generates tremendous cash flow and is a very high return-of-capital business.”

Bonds are the only debt in its capital structure, which is favourable for bondholders. “When Enova was spun out of Cash America in late 2014, we accumulated an equity position. We believe the stock was undervalued and the company has attractive growth potential.”

A key risk, which applies to all CEFs, is the possibility of large redemptions. Open-end funds can take in new flows every day. But, if a CEF raises $100 million when it IPOs, no more money can go in. Unitholders can redeem once per year, and many could head for the exit at once.

“A risk for investors who stay in the fund is, five years after the IPO, that $100-million fund may only have $50 million,” Hamlin says. “That’s a risk because it’s harder [for a manager] to put up fantastic numbers every year in a fund that’s shrinking in size.”

Cycles & Sectors

Dean DiSpalatro is a Toronto-based financial writer.