UTG, Closed End Funds, and Leverage

Many income-oriented closed-end funds (CEFs) use leverage - borrowing - in an attempt to increase returns. They buy interest- or dividend-paying securities with the money they have, and borrow additional money in some way to buy more securities. It works if the total borrowing cost is lower than the income & gains from the securities purchased.

It is not a free ride as it adds the typical risks of investing with leverage, which amplifies both gains and losses. If you buy investments that are extremely volatile in price, "highly leveraged" happens at a lower level than if you buy stable investments. A CEF prospectus should describe how the fund borrows money, how much leverage it can use, and how these risks are managed.

Also: CEFs trade at a discount or premium to net asset value, adding a risk factor absent with open-ended mutual funds. Nothing to do w/leverage. Add it up and if the goal is getting 1-2% more yield, an investor needs to understand that a leveraged, income, CEF has the potential for price swings much higher than that - up or down.

A good launch point for research is cefconnect.com which reports the current leverage, discount/premium, holdings, and SEC filings with the gory details. Like this one, as an example:

-Tad

Thanks for all this, Tad. I especially like the from-the-horse's-mouth (assuming UTG's managers are honest) document linked at the end. Thirty-six percent leverage as of January, oh m'goodness. I will pass this onto my relatives.

It's quite common for closed-end funds to use leverage. In fact, the average is probably somewhere around 20-30%. It's especially common for income-oriented funds which use leverage by borrowing short-term at low rates to hold positions in longer-term securities with higher yields. And it *certainly* is dangerous - if rates go up, the longer maturity securities (which effectively includes "perpetual" ones like preferred stock and other high-dividend equities) get clobbered while the interest rates on the rolled over short term debt used to finance it go up. Nevertheless, during times of stable (or declining) rates, this strategy can pay off handsomely. Not a free lunch, but still, a strategy which can work when used well.

As for the "whopping" 1.7% in fund expenses -- note that this includes both the management expenses *and* the interest paid on the borrowed funds. In the case of UTG, they've borrowed about $290million and paid about $3.8 million in interest (per the most recent annual report), so the nominal expense ratio versus the actual management expenses are not exactly the same, and it may be a little bit of apples-to-oranges to compare them against, say, unleveraged funds expense ratios.

None of this is meant to express any opinion of UTG itself - just some general information about leverage and funds.

Another couple of things to note: (a) the amount of leverage may change (especially if management is doing a good job and deleveraging when they should - it's not clear that anyone's all that great at that kind of market timing, though); and (b) additionally, closed-end funds trade on the secondary market and are subject to sometimes substantial discounts or premiums versus the underlying portfolio's NAV - this also adds potential opportunity or risk.

Thank you, David Meyers. This was interesting, helpful and will be shared with the aforementioned relatives.