ETFs of CEFs: Up To 9% Yields Available For Income Investors

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We’ve all heard the story dozens of times. The yield environment for income seekers is incredibly tough. The longest of long-term Treasuries still yield only 2%. The S&P 500 yields less than 2%. Junk bonds may net you 4%. There just aren’t a lot of options for investors if they want a livable yield from their portfolios.

That doesn’t mean there aren’t any options though.

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A lot of investors venture into the world of closed-end funds for high yields. At a fundamental level, they operate very similarly to ETFs, but there are some structural differences. CEFs issue a fixed number of shares, so the market value of those shares can fluctuate above or below the underlying NAV, known as the discount or premium. Many CEFs also utilize leverage in order to boost yield and total return potential. A lot of CEFs can be noticeably more volatile than traditional index-based funds, so it’s incredibly important to judge these funds on a case-by-case basis.

One of the biggest benefits of closed-end funds is that many offer yields of 7-8% or higher. On top of that, there are plenty of funds that offer monthly income distributions or fixed distribution schedules, very different from the ETFs that tend to generate quarterly variable dividend payments. This provides an added degree of flexibility and predictability that traditional ETFs may not offer.

Because of their unique nature, investors may benefit from the “fund of funds” structure. In other words, invest in an ETF that picks and chooses the best opportunities among closed-end funds in the same way that a fund may choose stocks or bonds. It’s an ideal option for investors interested in capturing the high yield opportunities in this space without doing a lot of research required to understand these funds individually.

According to ETF Action, there are 9 products out there that use a fund of funds approach that include CEFs to some degree. Some target the muni bond market. Others combine private credit exposure along with CEFs. One uses an extra degree of leverage to boost yields even more.

I’m going to highlight four of these “ETFs of CEFs”. They’ve all been around for several years and tend to take a diversified approach to building a portfolio. None of them is particularly large since this is still a relatively tiny corner of the ETF market, but they all offer current yields of 5-9%.

Amplify High Income ETF (YYY)

  • Distribution Yield: 8.6%
  • 3-Year Average Annual Return: 8.9%

According to fund literature, “YYY is a portfolio of 45 closed-end funds (CEFs) based on a rules based index. The ISE High Income Index selects CEFs ranked highest overall by ISE in the following factors: Yield, Discount to Net Asset Value (NAV), and Liquidity. This investment approach results in a portfolio which contains a variety of asset classes, investment strategies and asset managers.” With no individual CEF accounting for more than 3% of the portfolio at the time of reconstitution, there’s a high level of diversity that helps minimize some of the excess risk in any individual holding.

Currently, the overall portfolio is 88% fixed income and just 12% equity. Before you assume that a higher bond allocation automatically means lower risk, we’ll see shortly that the overall volatility level of YYY is actually comparable to that of the S&P 500. That’s due to the fact that many of these CEFs focus on riskier high yield bonds & senior loans, while the use of leverage from some of the funds also adds to risk.

More than half of the fund’s assets come from funds run by PIMCO, Nuveen, BlackRock, Eaton Vance or Franklin Templeton. These are some the biggest, most well-known and most successful issuers of CEFs.

Invesco CEF Income Composite ETF (PCEF)

  • Distribution Yield: 6.6%
  • 3-Year Average Annual Return: 11.6%

PCEF tracks an index that “currently includes closed-end funds that invest in taxable investment grade fixed-income securities, taxable high yield fixed-income securities and others that utilize an equity option writing (selling) strategy.” As it stands currently, the fund is diversified among these three groups in roughly equal weightings – 35% to taxable investment-grade fixed income, 28% to taxable high yield fixed income and 37% to option income strategies.

This fund’s strategy is relatively more conservative than those of other closed-end funds or even ETFs of CEFs. Covered call strategies may limit upside potential in exchange for high yield, but also limits some of the volatility of the portfolio. The high allocation to investment-grade bonds is also a bit unusual in an industry that tends to favor the high yield side.

PCEF is also a monthly dividend payer and has been incredibly consistent in the amount of its distributions over time.

Saba Closed-End Funds ETF (CEFS)

  • Distribution Yield: 9.1%
  • 3-Year Average Annual Return: 13.0%

CEFS is an actively-managed ETF that seeks to generate high income by investing in closed-end funds trading at a discount to net asset value, and hedging the portfolio’s exposure to rising interest rates. Saba Capital’s investment process includes proprietary screens that dynamically rank closed-end funds across a variety of factors including yield, discount to NAV and quality of underlying securities. The fund seeks to outperform index-based closed-end fund products by actively trading the portfolio in an attempt to capture the widening and narrowing of discounts to net asset value. It aims to hold about 40 positions at any given time.

CEFS invests in a split of roughly 2/3 fixed income and 1/3 equities, but is the highest yielding fund of the bunch. According to the latest information, the fund’s composition trades at a 8% discount to NAV. That’s a decent undervalued opportunity in the current environment, but not necessarily a huge one.

The interest rate hedge as part of the investment strategy is a unique feature and one that could pay off. The 10-year Treasury is already a full 1% above its recent low and could continue to move higher given the current high inflation rates and plans for the Fed to begin withdrawing its support of the economy.

First Trust CEF Income Opportunity ETF (FCEF)

  • Distribution Yield: 5.1%
  • 3-Year Average Annual Return: 12.2%

FCEF is also an actively managed exchange-traded fund. It utilizes a process where the available universe of CEFs are ordered by sector, strategy & size and then scored based on fundamental and performance factors. The fund’s managers also take into account factors beyond just yield and discount, such as liquidity and tactical opportunities, such as corporate actions, market pricing and calendar events. The fund’s model is overlaid with a top-down macroeconomic outlook to determine what the portfolio manager believes to be the most opportunistic areas in which to invest.

FCEF is the only fund of this bunch that focuses more on equity than fixed income. It currently has about 67% of assets in equity CEFs. If you consider just the pure numbers, FCEF is the smallest ETF listed with just $37 million in AUM, so trading costs could potentially be an issue. It’s also the lowest yielder and has a relatively small discount of 3-4% below NAV.

Risk Metrics

Given that CEFs, in general, tend to be more volatile than their peers and the broader market, it’s important to examine relative risk levels to see if the volatility is the worth the yield potential.

All of these funds have volatility levels that are actually pretty comparable to that of the S&P 500.

source: ETF Action

As mentioned earlier, PCEF has perhaps the most conservative strategy and that’s in line with it having the lowest standard deviation of returns. Only FCEF comes in higher, but not so much that it becomes a major consideration.

The one thing that sticks out is risk-adjusted returns. All four funds have a Sharpe ratio lower than that of the S&P 500 and a negative alpha. I know that the S&P 500 isn’t a true apples-to-apples comparison, but it’s difficult to find a true comp here. The use of the S&P 500 as a benchmark is merely to give a sense of risk/return potential relative to the broader market. It’s also worth noting that the last several years have been driven by returns in large-cap growth, something that these four funds don’t deal much in.

From a risk/return standpoint, CEFS looks like the best bet of the group (looking historically at least). It’s got the best total return, highest Sharpe ratio, lowest beta and lowest downside capture ratio. It’s also the highest yielder of the group at 9% right now.

Conclusion

ETFs of CEFs are a little known commodity in this industry, but they’re actually good options for generating high yields. The diversification factor helps bring risk levels back into range, something that is materially advantageous considering some individual CEFs can carry triple the volatility of comparables.

It’s important to remember that the majority, maybe even all at times, of total return will come from distributions. These are income vehicles above all else and investors should expect little in the way of capital growth to go with it. The monthly distribution schedules, however, will be an added bonus for those living off of their portfolios for income and the yield potential is certainly attractive.

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