Closed-end funds (“CEFs”) are different animals from exchange-traded funds (“ETFs”) and traditional mutual funds. CEFs do trade on an exchange, like stocks and ETFs, which leads to some confusion. However, they cannot create and redeem shares in response to changes in demand, and therefore are not ETFs. Investing in CEFs can be potentially lucrative, but investors need to be keenly aware of the price premiums and discounts, which are sometimes extreme, that typically accompany these investment vehicles. ETFs-of-CEFs provide an alternative approach for investors. Similar to fund-of-funds ETFs, these ETFs provide a portfolio of closed-end funds, greatly simplifying the process for investors.
Before jumping into the details on ETFs-of-CEFs, it is probably helpful to understand the world of closed-end funds. The key feature that makes an ETF an ETF is its ability to create and redeem shares. This, along with the continuous publishing of its intraday net asset value constitutes the soul of an ETF. These features provide the tools that allow professional arbitrageurs to keep an ETF’s trading price closely aligned to its net asset value throughout the day. If the creation/redemption mechanism is not functioning properly, then it becomes a “broken product” where premiums and discounts can develop. Traditional mutual funds only “trade” once per day at the closing, but all purchases are netted against all sales to determine how many shares need to be created or redeemed, so they also have a creation and redemption process.
However, closed-end funds generally do not create or redeem shares, except under special circumstances. The quantity of shares remains fixed, or “closed,” and trade independently of the underlying net asset value. Without the ability to create or redeem shares, there is no way to prevent price premiums and discounts from developing. This is the primary complaint about CEFs, and the reason why ETFs have greatly surpassed them in popularity.
Although this may seem like an obscure category of ETFs, there are eight such products currently on the market. When reporting expense ratios, the SEC generally requires ETFs and mutual funds to include the expenses of any other funds they hold. Therefore, the total expense ratios of ETFs-of-CEFs are composed of both a management fee for the ETF itself and the acquired fund fees for the CEFs it is holding. This gives these funds the appearance of higher-than-average expense ratios, but keep in mind that the reported yields and total returns are net of these fees.
Here are brief descriptions of the eight ETFs and ETNs that provide exposure to CEFs, listed in order of largest assets:
- PowerShares CEF Income Composite (PCEF), launched 2/19/10, tracks an index of closed-end funds that invest in taxable investment-grade fixed-income securities or taxable high-yield fixed-income securities, or utilize an equity option writing (selling) strategy. It has 140 holdings, $670 million is assets, and a current yield of 7.3%. PCEF has a management fee of 0.50% and acquired fund fees of 1.52% for a total expense ratio of 2.02% (PCEF overview).
- ETRACS Monthly Pay 2x Leveraged Closed-End Fund ETN (CEFL), launched 12/11/13, is an is an exchange-traded note (“ETN”) issued by UBS linked to the monthly compounded 2x leveraged performance of the ISE High Income Index of 30 CEFs, making it a leveraged version of the YieldShares High Income ETF (YYY) described below. This ETN has $261 million in assets, an investor fee of 0.50%, with the acquired fund fees being accounted for in the underlying index. The 2x leverage boosts both the price return and yield, with the ETN currently kicking off a 13.5% yield. The leverage and ETN structure are not for the faint of heart, and investors should fully understand these risks before investing (CEFL overview).
- YieldShares High Income (YYY), launched 6/12/12, tracks the ISE High Income Index of 30 CEFs ranked highest overall in fund yield, discount to net asset value, and liquidity. Its $154 million in assets currently have 75% exposure to bonds and 25% to stocks, producing a yield of 7.0%. YYY has a management fee of 0.50% and acquired fund fees of 1.36% for a total expense ratio of 1.86% (YYY overview).
- VanEck Vectors CEF Municipal Income (XMPT), launched 7/13/11, tracks an index of U.S.-listed CEFs that invest in U.S. dollar-denominated tax-exempt securities. It has 71 holdings, $80 million in assets, and a tax-exempt yield of 5.0%. It has a management fee of 0.40% and acquired fund fees of 1.16% for a total expense ratio that is capped at 1.56% (XMPT overview).
- First Trust CEF Income Opportunity (FCEF), launched 9/28/16, is an actively managed ETF with an objective of providing current income by investing in U.S.-listed CEFs. It has 40 holdings, $18 million in assets, and a current yield of 6.4%. It has a management fee of 0.85% and acquired fund fees of 1.65% for a total expense ratio of 2.50% (FCEF overview).
- First Trust Municipal CEF Income Opportunity (MCEF), launched 9/28/16, is an actively managed ETF that invests in U.S.-listed CEFs investing in municipal debt securities. It has 35 holdings and $12 million in assets with a tax-exempt yield of 3.7%. MCEF has a management fee of 0.75% and acquired fund fees of 1.16% for a total expense ratio of 1.91% (MCEF overview).
- Claymore CEF Index GS Connect ETN (GCE), launched 12/10/07, is an ETN issued by Goldman Sachs linked to the performance of the Claymore CEF Index of 75 U.S.-listed CEFs selected for discount and yield. It has about $7 million in assets. It has an investor fee of 0.95%, and the acquired fund fees are accounted for by the underlying index. The underlying index has a yield of 7.74%, giving the ETN an estimated yield of 6.8%. This ETN should be avoided, as it is essentially an orphaned product without a website and a longtime member of ETF Deathwatch (underlying index overview).
- Saba Closed-End Funds ETF (CEFS), launched 3/21/17, is an actively managed ETF that seeks to generate high income by investing in CEFs trading at a discount to net asset value and hedging the portfolio’s exposure to rising interest rates. It has 30 holdings and $6 million in assets. Although the ETF is new, its first distribution has been announced, giving the ETF an estimated yield of 7.9%. It has a management fee of 1.10% and acquired fund fees of 1.32% for a total expense ratio of 2.42% (CEFS overview).
Directly investing in CEFs is an option for investors, but I am of the belief that it requires a distinct set of skills, along with much time and effort, to successfully select and manage a portfolio of CEFs. For that reason, these ETFs may be an optimal choice for investors seeking income from CEFs.
From a performance standpoint, three of the unleveraged funds have been in existence for about 4.8 years. During that time, YieldShares High Income (YYY) has returned about 7.7% a year with a standard deviation of 12.1%, PowerShares CEF Income Composite (PCEF) returned 5.8% with a 7.9% standard deviation, and VanEck Vectors CEF Municipal Income (XMPT) returned 4.2% at 8.8% standard deviation. However, the three-year performance results greatly favor XMPT. Additional performance, risk, and liquidity information can be found in the 2017 ETF Field Guide.
I have previously owned PowerShares CEF Income Composite (PCEF) and VanEck Vectors CEF Municipal Income (XMPT) and was pleased with the results. I recently purchased YieldShares High Income (YYY). For investors seeking income, ETFs that own CEFs are certainly worthy of consideration.
Defensive Sectors at the Top
Defensive sectors are on the rise and already control the top of the rankings. Real Estate, one of the new-era defensive sectors, has joined Utilities at the pinnacle, and the traditional defensive sector of Consumer Staples sits in third. None of the factor ETFs were able to increase their momentum scores this past week, and the top of the global rankings remains a tight race.
Sectors: Last week, the primary discussion was the rise of Real Estate, as it climbed four spots higher and into the upper echelon. Today, Real Estate sits two notches above last week’s position, and it is now in a tie with Utilities for first-place honors. Traditionally, the “defensive sectors” consisted of Utilities, Consumer Staples, and Health Care. The reasoning behind this was that these were the sectors where consumers had to make expenditures even when the economy was bad. Their defensive nature typically resulted in them declining less than other segments during bear markets. However, what investors classify as defensive can change over time. The Telecom sector is often lumped in with this group because it has many of the characteristics of Utilities along with an above-average yield. Real Estate can be viewed as defensive since it can mitigate the effects of inflation in addition to its high dividend yield. Given these descriptions, it is clear that the Sector Benchmark ETFs are in a defensive posture, with Consumer Staples sitting right below the leaders. Additionally, Telecom climbed three places higher. Health Care, sitting in seventh, is the odd man out, which is likely due to its high degree of political risk at this time. Technology, Consumer Discretionary, and Materials fell in the rankings to accommodate the rise of the defensive sectors. Financials and Energy are still the only two sectors posting negative momentum scores, and this week they have fallen deeper into the red.
Factors: Unlike the show of strength among the defensive sectors, none of the Factor Benchmark ETFs were able to post a momentum increase this week. The five highest-ranked factors remain identical to a week ago, with Momentum and Low Volatility sitting in the #1 and #2 spots, respectively. Yield and Fundamental were both able to climb two positions, but they remain in the lower half of the rankings. High Beta was the only factor to fall in relative strength, and it dropped four places lower. Additionally, High Beta and Value slipped into negative momentum territory.
Global: The virtual three-way tie for first place among the Global Benchmark ETFs that was visible last week is there again today, although it is not composed of the same three categories. Latin America and Pacific ex-Japan are the two that held their spots, while the Eurozone dropped slightly out of contention and was replaced by Emerging Markets. Do not read too much into this, though, as a scan of the momentum scores reveals just a single-point difference among the top-five categories. With the score compression this high, the rank order has little significance. The U.K. and EAFE swapped places, producing the only changes in the lower half. All global categories lost momentum, and the U.S. dollar lost strength against most foreign currencies, keeping the U.S. near the bottom of the rankings. Japan is on the bottom for a second week and is barely treading water.
The following Edge Charts are market momentum snapshots. They provide a quick and easy way to help you visually get a handle on the overall state of the market. With these charts, you can assess both the relative strength and absolute strength (momentum) of more than 30 global equity market segments. Please refer to the Edge Chart User’s Guide for further explanation.
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and they think a great deal about what they do and how they do it.”
— Benjamin Graham
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