Many investors are making the right choice to build their core portfolios around low-cost, liquid and diversified exchange-traded funds (ETFs) geared towards dividend paying stocks and bonds. These funds provide transparent exposure to a broad range of asset classes without the drag of high expenses.
While this core exposure is important, there may also be a desire to diversify your holdings towards alternative investment styles with a penchant for higher yields. This is the foremost objective behind ETFs that invest in a basket of closed-end funds (CEFs).
Closed-end funds offer varying risk dynamics compared to traditional ETFs. They are pooled investment vehicles with set share amounts that can trade at a premium or discount to their underlying net asset value.
Furthermore, they often employ leverage, options and other sophisticated portfolio management techniques to boost their yields for shareholders.
The menu of available funds to choose from in the income-investing world is significant. So much so that selecting the most appropriate funds for your portfolio can be an overwhelming task. Particularly when you are trying to balance the right mix of quality and credit-sensitive investments to form a sensible strategy without taking too much risk. It’s always worth remembering that higher yields also encumber a higher risk of invested capital.
The following are five dedicated ETFs that invest in a broad range of CEFs for those investors that want to enhance the yield of their portfolio or seek out varying asset classes.
These ETFs of closed-end funds are not for everyone and will be most appropriate as small, tactical positions within a more diversified income portfolio. Their benefits will be felt most strongly in a credit-friendly environment with rising stock and high-yield bond prices.
Closed-End Funds to Buy: PowerShares CEF Income Composite Portfolio (PCEF)
Expense Ratio (including acquired fund fees): 2.02%, or $202 annually per $10,000 invested
Expense Ratio (just management): 0.5%
PowerShares CEF Income Composite Portfolio (NYSEARCA:PCEF) is the largest and perhaps most well-known fund in this category. This CEF has $667 million dedicated to an index of 140 closed-end funds.
The benefit of a fund like PCEF is that you get highly diversified exposure to virtually every corner of the closed-end fund market. It’s like owning the benchmark for this investment group.
The portfolio is allocated approximately 33% toward stock or option income strategies, roughly 37% towards bonds and 29% toward high-yield bonds. The current 30-day SEC yield is a generous 7.31%, and income is paid monthly to shareholders.
PCEF charges a management fee of 0.5% for the construction and maintenance of the fund. However, it’s total expense ratio is reported at 2.02% because of the additional 1.52% blended expenses of the underlying CEFs. These must be transparently reported according to securities guidelines.
An important aspect of analyzing closed-end funds is where they are trading in relation to their net asset value. PCEF currently sports a weighted average discount of -6.44%, which is on the high side in relation to its historical average. The 52-week low discount was -10.39%.
One of the best opportunities to buy CEFs and their ETF overlays is when discounts are expanding or premiums are contracting. This means that investors are selling regardless of the underlying price action of the portfolio. That’s where the value play is most attractive.
Closed-End Funds to Buy: YieldShares High Income ETF (YYY)
Expense Ratio (including acquired fund fees): 1.86%
Expense Ratio (just management): 0.5%
YieldShares High Income ETF (NYSEARCA:YYY) is another fund that has grown in popularity over its nearly four-year history. This ETF has $150 million dedicated to a more concentrated mix of just 30 holdings.
The YYY portfolio is constructed by screening for CEFs based on fund yield, discount to net asset value and overall liquidity.
The result is a unique mix of securities with the flexibility to change as the attributes of these underlying funds evolve. Think of it as a “smart beta” alternative to a more diversified and passive index. The current asset allocation is 25% stocks and 75% bonds.
YYY offers a 30-day SEC yield of 7.03% and its average discount is -8.01%. Dividends are paid monthly to shareholders as well.
This type of ETF may be appropriate for those that want to own a unique portfolio of CEFs with deeper discounts and higher yields than traditional benchmarks.
Closed-End Funds to Buy: VanEck Vectors CEF Municipal Income ETF (XMPT)
Expense Ratio (including acquired fund fees): 1.56%
Expense Ratio (just management): 0.4%
Investors that are looking for high yields in their taxable accounts may be drawn to a fixed-income fund like VanEck Vectors CEF Municipal Income ETF (NYSEARCA:XMPT).
This ETF has $78 million invested in a group of 71 diversified municipal bond CEFs. Most the holdings focus on national municipal fixed-income portfolios that produce federally tax-free income.
The purpose of this fund is to generate higher yields than a traditional muni ETF or even index mutual funds because of the use of leverage within the CEFs. CEF portfolios may also own riskier credit securities to boost their yields as well.
The current 30-day SEC yield is listed at 5.09%, which produces a taxable equivalent yield of 7.07% at a 28% federal tax rate.
Muni bonds have traveled a volatile path over the last 12 months as the hit of rising interest rates took their toll on this coveted sector. Nevertheless, those with a higher risk tolerance may find that a small tactical allocation to XMPT provides an attractive income stream.
Closed-End Funds to Buy: First Trust CEF Income Opportunity ETF (FCEF)
Expense Ratio (including acquired fund fees): 2.5%
Expense Ratio (just management): 0.85%
With First Trust CEF Income Opportunity ETF (NASDAQ:FCEF) we begin to explore the world of active security selection in closed-end funds.
First Trust released this ETF in late 2016 and it has accumulated $17 million in assets to-date. The portfolio currently owns 40 CEFs selected by the fund managers according to their objectives for current income and capital appreciation.
The prospectus for FCEF gives the managers wide leeway in selecting their portfolio based on fundamental and technical analysis. The fund can hold both U.S. and foreign stocks, alongside virtually every corner of the CEF bond universe.
The latest fact sheet identifies the portfolio in 25% stocks and 75% high-yield bond and fixed-income producing assets. The weighted average discount is -7.10% and the 30-day SEC yield is 6.38%.
The benefit of an actively managed fund is that they have the flexibility to move to cash or other less volatile funds to control risk. However, that benefit is a double-edged sword, in that they may miss the upside of an index if they aren’t in the right place at the right time as the market is rising.
Closed-End Funds to Buy: Saba Closed-End Funds ETF (CEFS)
Expense Ratio (including acquired fund fees): 2.42%
Expense Ratio (just management): 1.1%
Lastly, Saba Closed-End Funds ETF (BATS:CEFS), the newly released fund from Saba Capital Management is another actively managed variant run by a company that is familiar with CEF portfolio management.
Saba ranks CEFs based on their in-house models using factors such as yield, discount/premium characteristics and underlying portfolio quality.
Because this fund is literally in its infancy, it’s too early to evaluate the efficacy of its strategy as it relates to the peer group. CEFS hasn’t even declared its first dividend yet.
Nevertheless, I will be closely evaluating how the manager constructs and modifies this portfolio over time. It will be interesting to determine if their management style will be worth the higher fee in generating consistent returns and dependable income.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. Click here to download their latest special report, The Strategic Approach to Income Investing.