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After a very challenging fourth quarter of 2018 when the average closed-end fund (CEF) was lower by 8.7% and for the year was down 10.7%, CEFs staged a significant rally during the first quarter of 2019. The average fund was up 11.8% for the first quarter. It was a very broad-based rally with Equity CEFs up 14.8%, Taxable Fixed-Income CEFs positive by 11.2% and Municipal CEFs up 9.4%. As discussed in the fourth quarter 2018 CEF commentary (https://www.ftportfolios.com/Commentary/Insights/2019/1/28/fourth-quarter-2018), as tax loss selling ends and the calendar switches to the new year, price discovery takes hold as investors look to take advantage of the meaningful value and discounts to net asset value (NAV) that was created during the fourth quarter sell-off. That is, indeed, what we have seen occur in the first quarter. (Source: Morningstar. All data is share price total return).

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When Jerome Powell assumed the position of Chair of the Federal Reserve (Fed) in February of 2018, several questions lingered as to how he would guide the venerable institution. Would he be more of a hawk than his predecessor? Would he increase the independence of the Federal Open Market Committee (FOMC)? Would his investment banking background lead him to reduce the FOMC's market interventions in favor of a more "free market" approach? Would he accelerate balance sheet normalization? Would he dispel the notion of the "FED put" in the face of market volatility? Initially, it seemed that the answer to all the above questions was pointing towards, "yes."

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Despite some volatility along the way, biotechnology stocks have significantly outperformed the S&P 500 Index over the past couple years, a trend that began in earnest after the surprise results of the 2016 elections. Since then (11/8/2016 – 1/31/2019), the First Trust NYSE Arca Biotechnology Index Fund (FBT) has posted a cumulative return of 60%, outperforming the S&P 500 Index by 28%. Below is an update to an article we wrote last year on some of the trends in the biotechnology industry that we believe may contribute to continued outperformance looking forward.

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The fourth quarter was a very difficult one for the closed-end fund (CEF) marketplace. The average CEF was lower by 8.74% for the three-month period ended on 12/31/18. The sell-off during the fourth quarter helped contribute to what turned out to be an overall negative one for the average CEF in 2018. The average CEF was lower by 10.73% for the year. It was a broad sell-off as, on average, both equity and fixed-income CEFs were lower for the year. Equity CEFs were down 17.94%. Taxable fixed-income funds were weaker by 6.76%, while Municipal CEFs were lower by 5.95% for the year. (Source: Morningstar. All data is share price total return.) 

As is often the case, there were many varying factors which impacted the performance of equity and fixedincome CEFs, but clearly the negative performance for most U.S. and international equity indices hurt equity CEFs. Indeed, the MSCI All-Country World Ex US Index was down 16.42% for the year while the S&P 500 Index was lower by 4.39% during 2018. Rising short- and long-term interest rates hurt municipal CEFs, while many credit-sensitive taxable fixed-income CEFs were negatively impacted by investor fears that the global economy was slowing down. The BofAML Global Corporate Index was weaker by 3.46% for the year. (Source: Bloomberg)

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When equity markets have sold off over the past decade, many have been quick to point at exchange-traded funds (ETFs) as the possible culprit (remember the "flash crash"!?).  Plenty of active mutual fund managers have ample incentives to characterize ETFs as problematic, especially while facing consistent outflows, as ETFs continue to gobble up market share.  Thus, it's not uncommon for investment advisors to encounter clients that have had seeds of doubt planted about whether or not ETFs really are to blame when volatility picks up, or equities sell off.

Among such investors, these concerns may have been further stoked by an unexpected spike in volatility and equity market sell-off in Q418.  Surely, ETFs were to blame as nervous investors exacerbated the downturn by selling their ETFs into a declining market, right!? Nope.  If anything, the data points in the opposite direction. In Q4, US equity and sector ETFs had over $31 billion of net inflows. Even in December, as the S&P 500 Index had its steepest decline, US equity and sector ETFs had over $13 billion of net inflows. Meanwhile, traditional US equity and sector mutual funds had nearly $38 billion of net outflows in Q4.  If anyone was selling into a falling market, it was mutual fund investors!  However, before anyone starts blaming the Q4 market decline on traditional mutual funds, keep in mind that this is nothing new.  In fact, traditional equity mutual funds had net outflows for 8 of the prior 9 months in 2018, averaging over$11 billion per month.

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Mounting fears regarding the pace of interest rate hikes by the Federal Reserve, increased tensions between the U.S. and China over trade, and concerns over slowing global growth led to volatile conditions in both equity and fixed income markets during the final quarter of 2018. These fears led equities to fall 13.52% in the quarter, as measured by the S&P 500. The decline in equities during the quarter induced selling across a wide spectrum of asset classes, including high-yield bonds, which fell 4.64% and senior loans which were down 3.42%. The risk-off sentiment led to a flight to quality, notably into U.S. Treasury Bonds. As Treasury's increased in value, interest rates declined. The yield on the 10 Year U.S. Treasury Bond had its first quarterly decline since the second quarter of 2017 as the yield moved from 3.06% at the end of the third quarter to 2.68% at the end of the fourth quarter. Despite the volatility in the fourth quarter, senior loans outperformed most fixed income asset classes in 2018. Loans finished the year marginally positive at 0.47% (Exhibit 1) while high-yield bonds were down 2.25% (Exhibit 2), investment grade corporate bonds were down 2.24% and the Bloomberg Barclays Aggregate Index, a good proxy for the overall bond market, finished the year up one basis point.

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The weakness continued in emerging markets for the third quarter as the JP Morgan GBI-EM Global Diversified Index (the "Index") fell -1.83%. The yield on the Index rose 3 basis points (bps) over the quarter to 6.62% while similar duration 5-yr maturity US Treasury bond yields rose 22 basis points to 2.95%.

Although yields rose modestly for the emerging market (EM) asset class, the return from local currency bonds was positive over the quarter at 0.24% due to the high carry earned on the index. Weaker emerging market currencies versus the US dollar drove the volatility over the period. Emerging market currencies contributed -2.06% to the Index return over the period.

The continued rise in US Treasury yields is a concern for fixed income investors especially when comparing US domestic fixed income to global fixed income opportunities. With rising US Treasury yields the spread between international bond yields and US domestic yields compress. The less attractive pick-up in yield on the face of it shows that foreign bonds are now more expensive or less of a value proposition, however, that may overlook some of the benefits of diversifying globally when it comes to fixed income.

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