Closed-end funds had a market-price return of 26.2% in 2019, as measured by a linked benchmark consisting of the Morningstar U.S. All Taxable ex-Foreign Equity Closed-End Fund Index and the S-Network All Taxable ex-Foreign plus Capped Muni CEF Index.1 By comparison, the S&P 500 Index2 and the Barclays Capital U.S. Aggregate Bond Index3 had total returns of 31.5% and 8.7%, respectively.
Closed-end funds had strong gains in 2019, along with their underlying investments. Financial markets rallied amid accommodative Federal Reserve policies, encouraging U.S. economic data, better-than-expected corporate earnings results and progress in international trade negotiations. Moving forcefully to counter economic risks, the Fed reduced rates three times during 2019, reversing most of the rate hikes it had implemented during the prior 12 months. The economy saw further support from healthy levels of consumer spending, supported in turn by falling unemployment and gradually rising wages. International markets, most of which experienced weaker economic growth than the United States, rallied late in the year with improving manufacturing data and progress toward a U.S.–China trade agreement.
Closed-end funds' discounts to net asset value (NAV) narrowed across all major categories. The average discount on equity funds went from 6.9% to 3.3%, compared with the category's long-term average of 5.3%. The average discount on taxable fixed income funds went from 7.5% to 0.8%, tighter than the long-term average of 3.1%. Tax-exempt funds' average discount moved the most, dropping from 11.5% to 4.0%, slightly wider than the long-term average of 3.8%.
Real estate funds (43.4% return) were top performers in the equity category. Most equity-fund sectors had gains in the 25% to 35% range. Real estate was a notable outperformer, favored for its above-average and relatively stable, lease- based income. Master limited partnership funds (15.1%) had a relatively modest gain. MLPs had a strong start to the year, but were volatile in the second half of the period due to increased concerns about energy volumes and counterparty risk.
Investors in fixed income securities showed a preference for quality income. Within taxable fixed income, higher-quality sectors such as investment grade (31.6%) outperformed. Funds that invest in preferred securities (33.4%), which are issued mainly by large, regulated companies, also outperformed. Convertibles funds (36.3%) were a top performer, showing their typical sensitivity to moves in equity markets. The bank loan sector (16.7%) was a relative underperformer, restrained somewhat by a decline in interest rates in the period.
Closed-end fund IPOs picked up in the year. The year saw a total of 10 deals raising $5.1 billion in closed-end fund initial public offerings, the highest amount since 2013. A shift in the IPO structure, with investors no longer paying the up-front underwriting fees, along with buoyant asset markets and narrower than average secondary market discounts to NAV, all likely contributed to this renewed (but still relatively modest) interest in fund IPOs.
Given the likelihood of continued economic growth, the Fed could disappoint markets in the scale and timing of any further "insurance" rate cuts. Lower short-end rates should help the earnings power of levered closed-end funds and raise the appeal of a relatively higher-yielding structure; however, given the time lag it takes for those effects to flow through, any cuts currently priced in are effectively neutralizing past rate hikes. An eventual return to higher short- end rates would again challenge the earnings power for closed-end funds with leverage in their capital structure.
We believe that selectivity will remain key going forward, as broad measures of closed-end fund discounts have generally moved inside their historical averages this year. Valuations rarely stop once they reach historical averages, and with the current scramble for yield in full force, further discount narrowing may be the path of least resistance. With that said, we still see relative value opportunities within sectors, as specific fund mispricing remains a feature of the closed-end fund market.
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(1) Returns are based on market price. Prior to 7/31/19, the benchmark was the Morningstar US All Taxable Ex-Foreign Equity Index. Thereafter, it is the S-Network All Taxable ex-Foreign plus Capped Muni CEF Index. The S-Network All Taxable ex-Foreign plus Capped Muni CEF Index is a market capitalization-weighted index comprising all taxable closed-end funds and Diversified Municipal Bond Funds, except for single-country funds and region-specific equity funds The Morningstar US All Taxable Ex-Foreign Equity Index measures the market-capitalization-weighted total return of taxable equity and fixed income closed-end funds; it excludes international, regional and country closed-end funds. Index returns update frequently and are subject to change. All closed-end fund sector returns are based on Cohen & Steers calculations and classifications of the current U.S. listed closed end fund universe.
(2) The S&P 500 Index is an unmanaged index of 500 large capitalization, publicly traded stocks that is frequently used as a general measure of stock market performance.
(3) The Barclays Capital U.S. Aggregate Bond Index includes U.S. government, corporate and mortgage-backed securities with maturities of at least one year. Benchmark returns are shown for comparative purposes only and may not necessarily be representative of the Fund's portfolio.