Even the newest investors typically have a good sense of what it means to put their money into a stock. Mutual funds are also well known, thanks to their inclusion in employer-sponsored programs, such as 401(k) and 403(b) plans. In recent years, more investors have become familiar with exchange-traded funds, which often provide an inexpensive way to gain exposure to a particular index.
But individual investors have access to several other types of publicly traded investments that are not as well known. In some cases, the structure of the investment is somewhat complex. In others, it’s because the investment appears, for all intents and purposes, to be a stock. In those situations, investors often don’t realize that their investment has certain characteristics that set it apart from a stock.
Here are some investments that may appear similar to stocks, but have some distinct qualities. In addition, these are not always as familiar to investors as mutual funds or ETFs.
Closed-end funds. A closed-end fund trades on the public markets. Like a mutual fund, it holds a portfolio of securities. Unlike a mutual fund, it issues a limited number of shares at the time of its initial public offering.
One potential complication, relative to other investments: Closed-end funds may trade either above or below their net asset value.
That can give some investors pause, says Christian Magoon, CEO of YieldShares, a Downers Grove, Illinois, company that manages ETFs. Its High Income ETF (ticker: YYY) consists of 30 closed-end funds.
“In the land of ETFs or mutual funds, where you buy and sell generally at or around the [net asset value], closed-end funds are not like that at all,” Magoon says. “There’s the NAV. Then there’s the market price, which is where you’re buying and selling the closed-end funds, which could be above NAV, or more often, below NAV. Investors don’t like feeling like they’re selling a share of a closed-end fund for less than the underlying securities are valued. They really would like to sell at NAV for what those securities are worth or above that.”
However, a closed-end fund’s discount may offer opportunity.
“We’re in a period where we’re close to a 10 percent discount to NAV of the average closed-end fund, which is more than double the recent historic average. That, in my opinion, represents an opportunity to buy assets at a discount. Once those closed-end funds return to their historic discount levels, there will be about a 5 percent move for investors,” Magoon says.
Those discounts may result in relatively high dividend yields, which could be appealing for income-oriented investors.
“You have to be a little bit opportunistic if you’re looking at closed-end funds,” Magoon says. “You have to accept an increased amount of volatility.”
Real estate investment trusts. Plenty of investors like the idea of passive investment from real estate. However, that 3 a.m. call from a tenant with an overflowing toilet is a reminder that real estate isn’t necessarily a passive investment.
Real estate investment trusts offer exposure to residential- and commercial-property ownership, without the middle-of-the-night emergencies. REITs invest in mortgages or physical properties. Many are publicly traded and resemble stocks. In addition to fewer headaches, REITs are extremely liquid; the same cannot be said for a house that an owner would like to unload quickly but can’t.
“REITs offer an efficient way to own a piece of diversified real estate assets without a large amount of capital, participate in the income stream they produce and have daily liquidity to sell out when you want,” says Paul Jackson, president and chief compliance officer at Centurion Advisors in Sugar Land, Texas.
REITs can be appropriate for investors seeking an income-producing asset distinct from their existing stocks and bonds.
“Although REITs provide great diversification in a portfolio and have offered the highest return over the last 15 years of the major asset classes — stocks, bonds, commodities and cash — they also bring with them the highest volatility,” Jackson says. “Unless you are using REITs as a portion of your overall allocation — no more than 15 percent — don’t take a large position in them. Also, make sure to diversify your REITs, since many of them invest only in properties of a particular industry, such as retail centers, storage or health care.”
Master limited partnerships. Investors generally encounter master limited partnerships in the energy sector. An MLP is simply a legal structure that is required, by law, to generate the majority of its revenue from natural resources, commodities or real estate.
“Like any partnership, these businesses do not pay an entity-level income tax, but instead pass taxable income on to their partners,” says Brian Watson, director of MLP research and senior portfolio manager at Oppenheimer Funds’ SteelPath unit, based in Dallas. SteelPath manages four mutual funds that hold energy infrastructure companies, including those structured as MLPs, as the underlying investments.
“SteelPath’s focus on MLPs has little to do with their form of organization, but rather stems from our focus on energy-infrastructure investment,” Watson says. “Energy infrastructure assets consist primarily of oil and gas pipelines, terminals and treating facilities. It just so happens that the vast majority of energy infrastructure companies have chosen to be organized as an MLP. As such, energy infrastructure companies that are organized as C-corporations are also considered for investment.”
These infrastructure firms typically have fairly stable cash flow positions, because storage and transportation of assets is essentially independent of commodity-price volatility. In other words, if gas prices go up or down, that doesn’t affect revenue from transporting the fuel from one place to another.
“Any investor interested in adding hard-asset exposure to their portfolios might consider the asset class,” Watson says.
However, he adds, investors should be aware of tax consequences associated with MLPs. Someone who invests directly in a company organized as an MLP will receive a Schedule K-1, the IRS form that reports income passed through to an entity’s partners.
By investing in MLPs through a mutual fund or closed-end fund, an account owner enjoys the benefits of more simple tax reporting. Of course, the trade-off of owning MLPs in a fund may be the difference between a fund’s underlying holdings and its reported NAV. In addition, despite the stable revenue streams of infrastructure firms, investors often punish entire sectors for weakness in one sub-industry.
“It is important for investors to remember that MLPs are, in fact, publicly traded equities and can experience volatile trading just like any other publicly listed stock,” Watson says. “In fact, in recent months, the collapse of crude oil prices and the broader energy sector have led to energy infrastructure MLPs also exhibiting weakness. Though we would argue that energy infrastructure MLPs ought to trade with less volatility during periods of commodity price weakness due to their more stable margin profile, such correlation in periods of extreme volatility can and has occurred.”
Exchange-traded notes. Exchange-traded notes are often confused with ETFs. An ETN is similar to an ETF in that it tracks an index, trades on an exchange and tends to be low-cost and tax-efficient.
However, there is a significant difference. “While an ETF is a fund that typically owns all the components of an index, an ETN is a contractual obligation of an issuer — a debt obligation to be exact — that promises to deliver the return of an index,” says Christopher Yeagley, CEO of New York-based Level ETF Solutions, which develops and distributes ETFs. Before that, he headed ETRACS, the UBS business unit overseeing exchange-traded notes.
Yeagley says that distinction means ETN investors are subject to the issuer’s credit risk. “Very simply, if the issuing bank defaults on its debt, then you become a creditor to a bank with the potential to receive less than the contractual value of that ETN. Generally speaking, that risk does not exist with an ETF.”
With that understanding, ETNs are appropriate for individual investors seeking tax-efficient exposure to particular assets, Yeagley says. He also says the more complex products, such as leveraged ETNs, may be suited to more sophisticated investors.
Investors are most often best served by identifying their objectives, and then deciding if a particular ETN fits the bill.
“There are so many different kinds of ETNs, that I would say that the product type itself shouldn’t be the deciding factor. There are some excellent ETNs in the market. The determining factor should reside at the specific ETN. There are certain ETNs that I wouldn’t recommend for a retiree, just like there are certain stocks, bonds, ETFs and mutual funds that I wouldn’t recommend either,” Yeagley says.
Business development companies. Many investors would like the opportunity to invest in privately held companies, but there are some clear drawbacks. For example, traditional venture capital and private-equity funds are often limited to institutional investors or those with a high net worth. Also, even if the owner of a privately held company seeks a friends-and-family investment, it can be difficult to separate a brother-in-law’s optimism from a real opportunity.
Business development companies are essentially investment funds that specialize in providing financing to small, privately held companies, says Adam Freedman, chief investment officer at CircleBlack, in Princeton, New Jersey.
“While some private equity funds similarly provide financing to small, privately held companies, BDCs can be bought or sold on an exchange like a stock. That means that unlike with private equity funds, anyone can invest in a BDC, and money invested in a BDC isn’t locked up for years,” Freedman says.
BDCs are exempt from corporate tax as long as they distribute almost all of their yearly income to shareholders. As a result, their dividend yields are far higher than typically found in stocks and bonds, often exceeding 10 percent a year.
“But the high yield doesn’t necessarily mean that BDCs won’t lose value,” Freedman says. “Like stocks, they’re subject to the usual ups and downs of the market, and their unique characteristics mean they have some additional risks as well.”
One such risk is that by their very nature, BDCs tend not to invest in the safest companies. That’s partly because BDCs invest in smaller companies, which are often less stable than larger counterparts. In addition, the BDC funding available to privately held firms can be expensive. “So the companies that use BDCs may be higher-risk companies that can’t get funding from cheaper sources,” Freedman says.
A second unique risk is that BDCs may be especially vulnerable in a financial crisis. Because they distribute nearly all their income to shareholders, BDCs must constantly raise more money to finance their operations. “If financial markets seize up and it becomes difficult to raise more money, BDCs may struggle to survive,” Freedman says. “Investors should pay attention to this underappreciated risk when thinking about the role that BDCs should play in their portfolios.”
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ETNs, MLPs and REITs: Trading Off the Beaten Path originally appeared on usnews.com
