Consider closed-end funds

If you’re looking for income, consider 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.

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. 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.”

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.

Risk: 5/10 (in comparison, the S&P is 8/10)

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 in its initial public offering, 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.”

An open-end mutual fund has a potentially infinite number of units, which can be redeemed at any time. A closed-end fund has a fixed number of units, which are often traded on an exchange and aren’t always redeemable.