Many investors view closed-end funds as arcane, if not confusing investment vehicles, and instead prefer to invest in open-end mutual funds or exchange-traded funds. But there are now two ETFs that provide the simplicity of the open-end structure while investing solely in a basket of closed-end funds. The appeal of both funds, say their sponsors, is the potential to generate hefty yields.

The newer of the two funds, the YieldShares High Income ETF (YYY), debuted in June and in late August announced its first monthly distribution of 18 cents a share. That comes to $2.16 a share on an annualized basis, which based on the fund’s recent net asset value, equated to an annual distribution yield of about 9.35% (as of September 10).

YYY tracks the ISE High Income Index comprised of 30 closed-end funds (CEFs) chosen for their combination of yield, discount to net asset value and liquidity. No holding can exceed 4.25% at the time the portfolio is constituted, though a holding may grow larger than that during the course of the year (the fund is rebalanced annually).

The index, which was co-developed by the International Securities Exchange (ISE) and YieldShares founder and CEO Christian Magoon, has a 59% weighting in equity CEFs, 26% in debt CEFs and 15% in asset allocation CEFs. The last group includes funds related to currencies and convertible securities that don’t fit into the equity or bond categories. The top five CEF issuers by weight in the index are Eaton Vance, BlackRock, Nuveen, Allianz/Pimco and ING.

Closed-end funds are actively managed funds that are listed on securities exchanges and have a fixed number of shares that trade throughout the day in the open market––usually at a discount or premium to a fund’s underlying NAV. Several factors can cause a CEF’s market price to diverge from its NAV, and CEFs often trade at sizable discounts.

Roughly 600 CEFs trade in the U.S., and they tend to have specialized portfolios and to focus on an investment objective such as income or capital appreciation.

YYY tries to capture what Magoon describes as the appealing aspects of CEFs: income-generation potential and the ability to buy CEFs at a discount. CEFs can use leverage to boost income by issuing preferred shares, borrowing from banks or other methods. In addition, Magoon says, the majority of the equity CEFs in YYY employ a covered call writing options strategy to generate income.

Buying funds at a discount means you’re paying less for the same distribution dollar amount, which boosts the distribution rate. It can also result in capital appreciation if you sell a CEF at a smaller discount––or, better yet, at a premium––to the original purchase price. The average discount among the CEFs in YYY’s underlying index is 7.11%. Magoon says that during the past 10 years ended April 2013, the average closed-end fund has traded at a 3.5% discount to NAV.

“That bodes well for our fund,” he says, noting that YYY can benefit from price appreciation if its underlying CEFs sell at a smaller discount or at a premium to the original purchase price when the fund’s first annual rebalancing occurs on December 31.

The flip side of employing leverage and covered call writing strategies is that they can make portfolios riskier. Magoon notes that the average leverage employed among CEFs in the debt portion of YYY is roughly 30%. “That can make them more volatile than their underlying asset class,” he says.
And there’s the risk that YYY might sell some of its funds at a greater discount than the purchase price when it reconstitutes its portfolio, which could hurt the fund’s performance.

This is the first fund from YieldShares, but Magoon is an ETF industry veteran who formerly was president of Claymore Securities (now Guggenheim Funds) and has helped launch more than 50 ETFs.

The Incumbent
Investors looking for something with a longer track record can consider the PowerShares CEF Income Composite Portfolio (PCEF), which debuted in February 2010 and has assets of roughly $450 million. The fund’s annualized return since inception was roughly 6.5% (as of September 10), and its expense ratio of 1.73% is 8 basis points more than the YYY fund.

PCEF tracks the S-Network Composite Closed-End Fund Index of 146 CEFs spread across three income categories: investment-grade bonds, high-yield bonds and equity-option income. The last category comprises roughly 40% of the fund’s portfolio, while bond CEFs make up the rest.

During the past year, PCEF’s monthly distributions have averaged more than 16 cents, and its recent distribution yield was 8.13%.

“We’re not specifically targeting funds with a minimum yield, but our targeted fund categories historically have attractive yields,” says Joe Becker, senior income product strategist at Invesco PowerShares.

The fund also doesn’t screen for funds trading at discounts. Among its CEF selection criteria, all holdings must have a market cap minimum of $100 million, have a three-month average daily trading volume of more than $500,000, and trade at less than a 20% premium to their NAV.

PCEF rebalances quarterly, which Becker says can help the fund dance around the closed-end premium/discount tango. “If a particular fund has traded down to a discount to NAV, the PCEF index methodology may add to that fund, which has potential to be good for investors,” he says, noting that the index’s weighting system puts a greater emphasis on funds trading at larger discounts. 

“If a particular fund runs up and trades at a premium, the PCEF index methodology may take some of it off the table and move it into funds trading at bigger discounts,” he adds. “That potentially could help with price return and the portfolio’s total return.”

Becker says PCEF’s broader portfolio of 146 holdings should give it a smoother ride than the rival YYY’s concentrated portfolio of 30 funds. In turn, Magoon says YYY’s greater emphasis on equity CEFs employing covered call strategies should produce more income than PCEF’s bond-heavy portfolio.

Look Out For Rising Rates
PCEF has attracted significant assets during its three-and-a-half year existence, so clearly there’s demand for an income strategy based on closed-end funds. But as mentioned above, closed-end funds can be volatile––indeed, the group got whacked during the recession, with some trading at discounts to net asset value of as much as 25%.

Meanwhile, the threat of rising rates as the Federal Reserve unwinds its bond buying program could negatively impact closed-end funds that use leverage, since leverage costs are tied to short-term interest rates. And higher rates can also cause price depreciation of the underlying bonds in debt-focused CEFs.

The average duration of the bond portion of the YYY fund’s underlying index is 6.1 years. But after adding the equity and asset allocation portions of the fund into the mix (neither of which have duration risk), the overall index duration becomes 1.57 years. Magoon believes the fund’s low duration should offer protection when QE tapering occurs and interest rates ultimately rise.

As for PCEF, Becker says calculating the fund’s overall duration across its 146 holdings is “virtually impossible” given the difficulty of acquiring all the data and the lag times in how the CEFs report their underlying holdings.

“PCEF is a yield-based product, so it will not be immune from rising rates should that be the result of the end of QE,” Becker says. But, he adds, the fund’s high yield means that it’s generally less sensitive to changes in interest rates than something with a lower yield.

These are important points to consider for investors who are attracted to the enticing yields offered by these two funds.