Many income investors are finding themselves in a conundrum that I have been talking about for some time now. The crux of the issue is that prices on dividend paying equities has risen to the point where generating a decent yield is tougher than ever. Right now the iShares Select Dividend ETF (DVY) pays a 30-day SEC yield of just 3.05% and many traditional fixed-income funds have seen their yields fall to that level or lower.
For some, the solution is to go farther out on the credit spectrum to include junk bonds, preferred stocks, mREITs, and MLPs in their portfolio. However, even those securities have benefitted from the search for yield in that new money added at these high levels is capturing the lowest income stream in years.
One potential solution to this problem is to turn towards closed-end funds as a diversification and aggressive income solution.
What Is a Closed-End Fund?
For those that aren’t aware, a closed-end fund (CEF) is similar to an ETF in that it is a basket of underlying securities that is traded throughout the day. However, most of the similarities end there. CEFs are created by an initial public offering that raises money to seed the fund and is then actively managed according to the constraints of the prospectus. Unlike ETFs, which create and redeem shares throughout the day, CEFs have a fixed number of shares and can therefore trade at a premium or discount to the fund’s net asset value.
The benefit of a CEF is that the fund manager is able to actively select and hold investments according to their research and analysis expertise. Because the number of shares is fixed, they do not have to sell distressed holdings at inopportune times to satisfy redemption’s. In addition, CEFs are able to use leverage and unconventional strategies, such as options, to enhance their returns over time.
How Can I Incorporate Them Into My Portfolio?
There are currently hundreds of closed-end funds available in the market that investors can purchase and build an income portfolio around. However, selecting a basket of CEFs may require a great deal of research to properly screen and understand their individual strategies.
Fortunately, there are several ETF options that are available as well. The Powershares CEF Income Composite Portfolio (PCEF) and YieldShares High Income ETF (YYY) are both exchange-traded funds that hold a basket of closed-end funds. Simply put, these ETFs allow you to own multiple CEFs in a diversified mix that includes both equity and fixed-income holdings.
PCEF is the oldest and largest of the two with nearly $600 million of total assets invested in 153 closed-end funds. The current 30-day SEC yield is 7.23% and income is paid on a monthly basis to shareholders. This ETF is overweight fixed-income with 67% of the portfolio weighted towards bonds and 33% in stocks.
The current management fee of PCEF is listed at 0.50%, however there is also acquired fund fees and expenses listed at 1.27%. These additional expenses are considered to be the pro-rata share of the management fees from the underlying closed-end funds that PCEF invests in.
So far this year, PCEF has gained 7.15% in total return as a result of the accommodative interest rate and equity environment favoring these holdings. In addition, many of the underlying closed-end funds have experienced narrowing of discounts to their NAV since the beginning of 2014, which has propelled this ETF higher.
YYY on the other hand is a newer fund that has nearly reached its first full year of track record. This ETF has seen its assets grow to over $54 million in a relatively short period of time as investors have been attracted to its income and asset allocation characteristics.
YYY uses a concentrated portfolio of 30 CEFs that include both equity and fixed-income holdings. This ETF has 58% of the portfolio dedicated to equities, 38% in bonds, and 4% in multi-asset funds. The underlying CEFs are selected according to three criteria that include: fund yield, discount to net asset value, and fund liquidity.
The current 30-day SEC yield of YYY is listed at 7.99% and so far this year, the fund has gained 8.49% in total return. YYY has a similar management fee of 0.50% and acquired fund fees and expenses of 1.16%.
The biggest differentiating factor between PCEF and YYY is the asset allocation strategy. YYY takes an overweight position in stocks, while PCEF is more heavily weighted towards fixed-income assets. This has contributed to an outperformance in YYY over PCEF of approximately 4% during the last 11 months.
The Bottom Line
There are a number of risks involved in investing in closed-end funds that include the use of leverage, return of capital as income, and arbitrage between price and NAV. I would caution new investors to carefully research and understand how these funds work prior to adding them to your portfolio. However, savvy income investors have been using these vehicles for years to generate high yield and capital appreciation through unique actively-managed strategies.
A diversified approach to CEF investing using an ETF wrapper may offer additional diversification qualities to help mitigate adverse effects of any one fund. In addition, the multi-asset qualities can help balance out volatility while still keeping monthly quite income high.