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ETF Specialist

Yield Sucker Bet

A look at the biggest exchange-traded fund of closed-end funds.

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A version of this article was published in the December 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.

There are good and bad ways to achieve one's income targets. The good way takes into account risk and total return. The bad way ignores risk and focuses on income at the expense of total return.

A year ago, bond closed-end funds as a whole were a bad way to get income. They were trading at the highest premiums in at least 15 years. Then-Federal Reserve chairman Ben Bernanke's "taper talk" last May sent yields up and shook lots of investors out of anything that had a whiff of duration, including CEFs. Discounts have remained relatively wide since.

Data from Feb. 19, 2010 to April 22, 2014.
Sources: Morningstar Direct, Morningstar Traded Funds Center.

I looked at PowerShares CEF Income Composite Portfolio (PCEF) as a diversified bet on the sector's wide discounts. This exchange-traded fund tracks the S-Network Composite Closed-End Fund Index, a basket of about 150 bond and option-writing CEFs. The index applies a modified net asset value weighting scheme where CEFs trading at wider discounts are weighted more heavily. Historically, the index's aggregate discount has been at least several percentage points deeper than the broad CEF sector's, a promising sign.

That said, I'm skeptical of PCEF's utility. PCEF is borderline indiscriminate in its selection of funds. By owning so many, the individual bets of its CEFs cancel out to create a generic credit bet. Since inception, it has behaved like a higher-volatility, lower-return high-yield bond fund. Exhibit 2 shows PCEF's total return against  iShares iBoxx $ High Yield Corporate Bond (HYG) and the market. I don't expect PCEF to do any better in the future.

Data from Feb. 19, 2010 to April 22, 2014.
Sources: Morningstar Direct, Morningstar Traded Funds Center.

While PCEF screens out CEFs with expense ratios higher than 2.00%, it tacks on a 0.50% management fee and ends up charging an aggregate 1.77% expense ratio.

PCEF's expense ratio greatly understates its all-in costs. First, the illiquid bonds that many CEFs invest in are not cheap to trade. Second, CEFs themselves are relatively illiquid and not cheap to trade, either. A relatively liquid CEF might have an average daily trading value of $5 million. It doesn't take much to push around a CEF's market price. PCEF has about $570 million in assets, meaning a 1% deletion or addition could easily overwhelm the daily liquidity of the CEF being traded. Some of PCEF's holdings have market caps as low as $100 million or average daily trading volumes as low as $500,000. This is a big problem. PCEF has averaged 29% turnover during the past four years.

The fund's one saving grace is its contrarian rebalancing and weighting scheme. If you're wildly optimistic, you may think it will add enough value to overcome its high fees and frictional costs. I doubt it will. I would not own this fund, nor would I recommend it. If you do, I suggest you exit and buy a selection of carefully chosen CEFs.

Rolling Your Own
I don't see why an investor couldn't buy, say, three or four CEFs and do better than PCEF. I'm a believer in compact fund portfolios. While owning lots of funds may seem like prudent diversification, the vast majority of idiosyncratic risk within an asset class is neutralized by any reasonably diversified fund.

Oddly enough, a good starting point is PCEF's top holdings. PCEF's index screens out CEFs with high fees, big premiums, and small asset bases, and it overweights the most-discounted funds.

Good CEF opportunities have several characteristics:

1) A sizable discount relative to its own history and to similar funds. Notice I said discount. CEFs trading at premiums are rarely good purchases.

2) Insider ownership, preferably increasing. Most investors--myself included--do not have the resources and skills to conduct fine-grained analysis of a CEF's holdings. A CEF's managers do.

3) Undervalued assets. A discount doesn't help you if you're buying an overpriced asset.

4) Low fees (and if not low, at least offset by a big discount). Ideally, the fees would be charged on net rather than gross assets.

It's rare to find funds with all four characteristics.

Back in December, when this analysis was first made available to ETFInvestor subscribers, I recommended three funds that met most of these criteria: PIMCO Dynamic Income (PDI), PIMCO Dynamic Credit Income (PCI), and  BlackRock Credit Allocation Income (BTZ). (Full disclosure: I own PDI and PCI personally and in the ETFInvestor portfolios.) Out of curiosity, I compared how an equal-weighted portfolio of them would have done against PCEF. PCEF returned 7.7%, including reinvested distributions. Our picks returned 13.3%, about half coming from discount compression.

Data from Dec. 12, 2013 to April 22, 2014.
Sources: Morningstar Direct, Morningstar Traded Funds Center.

As a group, the funds are still reasonable buys today as replacements for current credit holdings. However, their margins of safety have eroded. Their discounts have narrowed and so have credit spreads. Fixed-income CEF discounts are still historically wide, but much of that benefit has been offset by high valuations. Tread carefully.

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Samuel Lee does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.