Yesterday (2/19/2010) was the first day of trading for PowerShares CEF Income Composite Portfolio (PCEF). This is an ETF whose portfolio consists of closed-end funds. In other words, PCEF is a “fund of funds.”

Closed-end funds (CEF) have been around for decades, and were in fact an ancestor of today’s exchange-traded funds. The primary difference is the creation/redemption mechanism. ETFs allow new shares to come into existence in large blocks, or be removed from trading in the same way. The resulting arbitrage is what keeps ETF market prices in line with the net asset value.

There is no such process in closed-end funds. Consequently the shares can trade at a substantial premium or discount to the underlying portfolio’s value. CEFs are sometimes regarded as illiquid securities that brokers palm off on unsuspecting clients. They can, however, be useful for very long-term investors. The structure is particularly suited to income-oriented assets.

PCEF tracks an index of closed-end funds that assigns higher weight to closed-end funds trading at a discount. This partially offsets the liquidity problem and offers more diversification than a CEF. On the other hand, as a fund-of-funds PCEF is subject to a double layer of fees. PowerShares has a 0.50% expense ratio at the ETF level, and the component funds average out to another 1.31%. The total of 1.81% is extremely high for an ETF. PCEF will need to deliver superior performance to overcome this hurdle.

Another issue is that PCEF is exposed to all the risks of the underlying closed-end funds. The index includes component funds that may use leverage and other aggressive techniques. This could make PCEF more volatile than some investors expect.

PCEF is not the first exchange-traded product to cover this territory. Claymore CEF Index GS Connect ETN (GCE) is an exchange-traded note with similar objectives. The ETN structure is problematic, plus Claymore seems intent on making sure no one knows GCE exists. My guess is that PCEF will quickly surpass GCE in assets.

PCEF Overview

PCEF Prospectus (PDF file)

Disclosure covering writer, editor, and publisher: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.