Income Investing: An ETF That Buys CEFs

Forbes featured an interesting article titled “Fixed-Income ETF For Income And Gains.” Let’s listen in:

This fund kicks out a decent yield, and I wouldn’t be surprised to see some decent capital appreciation down the road.

We have heard of closed-end funds buying exchange-traded funds as part of their portfolio; it only makes sense. After all it is a fast way to invest in the market or a market segment quickly, cheaply and easily.

Turnabout is fair play, and ETF creators have come up with a twist, an ETF that buys closed-end funds. The PowerShares CEF Income Composite Portfolio ETF (PCEF) invests in income-producing closed-end funds that use three different investment approaches. The broad classes are investment-grade, non-investment-grade and buy-write option funds.

Investment-Grade Fixed Income Funds:

Investment-grade government and corporate bonds, mortgage-backed securities and preferred stock–these are securities rated equal to or higher than BBB. About 44% of funds are invested in this approach.

High-Yield Fixed-Income Funds:

Non-investment-grade bonds of corporations, banks or sovereign debt, rated below BBB. About 18% of funds are invested with this approach.

Covered call funds or buy-writes:

These closed-end funds buy common stocks and write call options on their position to generate income. About 38% of funds are invested in this class of funds.

The fund sponsors claim the benefit of the new ETF is that it offers diversification by asset class, investment strategy and investment manager. In addition to such diversification, the fund offers high current yield and a high discount to net asset value in its holdings.

The fund’s rules for investing include buying closed-end income funds that have a market cap of at least $100 million and an expense ratio of less than 2%; funds must trade at a premium of less than 20%.

PCEF will increase the weighing of certain funds as their discounts increase and will decrease weightings when the discounts shrink. The current makeup of the fund has an average discount of –4.17% and a yield of 8.59%.

We like this ETF for the same reasons we like closed-end funds: the opportunity to buy $1 worth of stock for 90 cents. The fund is buying a significant portion of the closed-end income fund universe, giving the holder instant diversification.

We would prefer an entry point with a deeper discount than is currently available, but we like the idea of the fund and will keep an eye on it as a possibility for future investment. Now all we need is a closed-end fund that buys this ETF, and we have a snake-eating-its-tail situation.

As you can see from the chart above, this fund is fairly new. However, it’s impressive that it is already trading at an average volume of around $3 million per day. I checked the bid/ask spread, and it’s only 1 cent.

For testing purposes, I purchased $150k for my own account, which represents about 5% of average daily volume, and I had no problem getting my limit order filled.

This is not meant to be a promo for this fund, but I believe it may have merit down the line once more price and distribution data becomes available. I will then add it to the bond investment table of my StatSheet as well.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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