Many investors are making the right choice to build their core portfolios around low-cost, liquid, and diversified 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 further 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 than a traditional ETF. 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 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.
PowerShares CEF Income Composite Portfolio (PCEF)
PCEF is the largest and perhaps most well-known fund in this category. This ETF 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% towards stock or option income strategies and 67% towards high yield fixed-income. The current 30-day SEC yield is a generous 7.31% and income is paid monthly to shareholders.
PCEF charges a management fee of 0.50% 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 closed-end funds 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.
YieldShares High Income ETF (YYY)
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 end 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. The fund charges a similar management fee of 0.50% and carries underlying fund expense fees of an additional 1.36%.
This type of ETF may be appropriate for those that want to own a unique portfolio ofCEFs with deeper discounts and higher yields than traditional benchmarks.
VanEck Vectors CEF Municipal Income ETF (XMPT)
Investors that are looking for high yields in their taxable accounts may be drawn to a fixed-income fund like XMPT. This ETF has $78 million invested in a group of 70 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. The CEF portfolios may also own riskier credit securities in order 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. XMPT charges a management fee of 0.40% and its net expense ratio is listed at 1.56%.
Muni bonds have traveled a volatile path over the last twelve 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.
First Trust CEF Income Opportunity ETF (FCEF)
With 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 of 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.
FCEF comes with a management fee of 0.85% and total net expense ratio of 2.50%. 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 out on the upside of an index if they aren’t in the right place at the right times as the market is rising.
Saba Closed-End Funds ETF (CEFS)
Lastly, the newly released fund from Saba Capital Management is listed under the ticker CEFS. This 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.
The fund charges a management fee of 1.10%, which is on the high side for this group. The total fund expense ratio is listed at 2.42% based on the initial holdings.
Because this fund is literally in its infancy, it’s too early to evaluate the efficacy of their 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.
The Bottom Line
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 ETFs mentioned above 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.