The Lazy Way to Get High Yield at a Discount
Everyone likes a good bargain.
But it’s often hard to press the “Buy” button when good stocks finally hit the bargain bin.
That’s because such selloffs are typically driven by fear.
And fear causes investors to second-guess their strategy, even when their favorite stocks are selling at dream prices.
After all, some value plays can turn out to be value traps.
But what if there were a security that let you buy assets at a discount to their market price?
And what if it also had a high yield?
That probably sounds too good to be true.
In fact, there is such a security.
But it occupies an obscure corner of the investment world. And few investors know it exists.
The Market’s One True Bargain
By now, you’re probably wondering what this mystery security is.
I’m talking about closed-end funds (CEFs). They were created back in 1893, more than 30 years before the first mutual fund.
Like mutual funds, CEFs are actively managed portfolios.
Unlike mutual funds, CEFs trade on public exchanges. And their share counts are generally fixed.
These two attributes can cause a CEF’s share price to trade above or below the actual value of its portfolio.
When a CEF’s shares trade at a discount to the value of its portfolio, that’s one of the only times the market gives you a true bargain.
Value Plus Income
Now, let’s talk about yield.
Many CEFs have high and rising yields of 6% or more.
To boost yield and returns, many CEFs borrow some of the money they invest.
But not all fund managers use this tactic shrewdly. And when they don’t, you can get burned.
Further, some CEFs even resort to financial gimmicks to give the illusion of high yield.
The source of a high-yield CEF’s payout should generally come from dividends, interest, or capital gains.
However, some CEFs will actually return investors’ own money to them after deducting fees for management.
If you don’t know where to look, you might actually fall prey to this outrage.
The Answer in Alphabet Soup
Clearly, there’s a lot to understand when it comes to CEFs.
Learning the ins and outs of this niche can be downright daunting—even if you do all your homework.
But if you’d rather delegate this task to others, then Wall Street is happy to oblige.
Indeed, there are exchange-traded funds (ETFs) that invest in CEFs.
ETFs that invest in CEFs? Yep, that’s a lot to wrap your head around.
There’s another way to think of this veritable alphabet soup.
What we’re talking about here is a fund that invests in other funds.
A regular mutual fund gives you safety in numbers.
Even a veteran fund manager won’t always get things right. But he can get a few things wrong from time to time and still have a winning portfolio.
A fund of funds takes the safety in numbers concept even further.
This lowers the risk of mistakenly investing with a bad fund manager—or investing with a good fund manager whose hot hand turns cold.
More important, it gives you instant diversification. In fact, a fund of funds gives you far more diversification than you could ever get in a regular mutual fund.
The Young Grandpa
ETFs that invest in CEFs haven’t been around all that long.
Even the one that’s been around the longest—PowerShares CEF Income Composite Portfolio (NYSE: PCEF)—only started back in 2010.
But PCEF’s track record is long enough to give us comfort that it can offer both growth and income.
The ETF currently yields nearly 7%.
The source of that yield is a portfolio that holds nearly 150 CEFs.
And while the various strategies are diverse, the vast majority of PCEF’s holdings focus on bonds—investment grade (37% of assets) and high yield (30% of assets).
The balance is invested in funds that specialize in low-risk strategies that use options to generate income on stocks.
PCEF has done a good job of keeping pace with its benchmark, with a total return of nearly 7% annually over the past five years.
The main caveat is that PCEF was launched in an era of historically low interest rates. We don’t yet know how the fund will perform in a rising-rate environment.
But odds are this isn’t the first rodeo for many of the fund managers who run the CEFs in which PCEF invests. Many were probably at the helm the last time interest rates were heading higher.
Further, PCEF’s index automatically adjusts the fund’s holdings by buying CEFs at discounts to the value of their assets and selling them at premiums.
In other words, it buys low and sells high.
Right now, for instance, its holdings trade at a 5.3% discount to the value of their portfolios.
This approach should also help the fund weather the challenges of higher rates.
Still, it’s important to consider the risk of funds that borrow money to invest in bonds now that rates are rising.
The Small Print
The other thing you should know is that delegating will cost a bit more than if you do it yourself.
The funds in PCEF’s portfolio charge management fees, and, of course, the ETF has a management fee of its own.
That means you’ll be paying a fee on top of another fee.
The good news is that PCEF isn’t too greedy when it comes to its own fee, which is 0.5% annually.
But CEFs typically charge higher fees than the average mutual fund because their strategies incur additional costs.
The average fee charged by PCEF’s holdings is around 1.5% annually.
So the total expense of investing in PCEF is about 2.0% annually.
At a time when fund fees are low and heading lower, this may be a deal killer for most.
And, in general, the lower your fees are, the better your long-term returns will be.
But PCEF’s fees are not unreasonable for what it does. And since high yield doesn’t come without higher risk, it may be worth paying up for safety in numbers.