CEFS has a rough balance of 75% fixed income and 25% equity, but it’s run by active managers. It seeks to generate high income and hedging for duration risk as the Fed raises interest rates, and the managers use proprietary models to rank closed-end funds across a variety of factors, including yield, discount to NAV and the quality of the underlying securities. CEFS’ share price this year was down slightly as of early autumn.
YESR, the YieldShares fund sponsored by Amplify ETFs, is the smallest of the fixed-income focused funds, at $3.6 million in AUM. That fund was up about 2.5% this year.
While most of the closed-end fund ETFs focus on either fixed income or a mix of fixed income and equities, YYY from Amplify ETFs and the First Trust CEF Income Opportunity ETF (FCEF) take a “go-anywhere” multi-asset class approach.
The YYY fund has a 75% fixed income, 25% equity asset allocation, but that can change at rebalancing. “It looks for the biggest discount in any asset class—fixed income, equities, commodities, MLPs, etc.,” Magoon says about his fund. “That’s why it might not always fit in an equity sleeve or a fixed-income sleeve in any given year.”
The YYY fund tracks the ISE High Income Index comprising 30 closed-end funds with the highest ISE rankings in three criteria: the fund’s yield, its discount to net asset value and its liquidity. This ETF rebalances annually in late December to take advantage of the dislocations in the market at the time when discounts tend to widen for year-end tax-loss selling. Its share price was barely in positive territory for the year, but it had a solid three-year annualized gain of 9.65% and average five-year returns of roughly 5%.
The FCEF fund takes a global, multi-asset, actively managed strategy to produce income that can have exposure to U.S. equity, fixed-income securities and commodities. Although it is primarily focused in the U.S., with 75% of its holdings domestic, it also has European and Asian closed-end funds, each region representing 12% of it. The fund manager uses a proprietary model, as First Trust’s MCEF fund does, to select and sort closed-end funds based on sector, strategy and size. The fund was down almost 4% this year.
A Substitute For High Yield
Toroso’s Dziekanski said that as of September his firm employed six of the seven closed-end fund ETFs in its portfolios. He calls them “absolutely phenomenal” offerings. By buying closed-end funds in an ETF wrapper, he notes, investors get the usual basic benefits of the ETF structure in addition to having someone do the quantitative analysis on the chosen funds. He also notes the advantages of taking income that isn’t capital gains.
But he cautions that these are investment tools and not core holdings like a plain vanilla S&P 500 ETF. “These very much should be managed. They’re not end solutions for the entire portfolio,” Dziekanski says.
Closed-end fund ETFs are often used as a replacement for high-yield fixed income, Jordan says. She notes that, given the uncertain outlook for fixed income amid rising interest rates, closed-end fund ETFs could give investors the income they need without burdening them with the same risk high-yield ETFs do—an advantage of the discounts that closed-end fund ETFs offer.
“If you’re going to have 100 cents of high yield in HYG [the iShares iBoxx $ High Yield Corporate Bond ETF], wouldn’t you rather take 11 cents off the table and have 89 cents of this closed-end fund that offers the exact same yield because of the discounts?” she asks.
She posits that the closed-end fund structure—both closed-end funds and closed-end fund ETFs—makes them safer than open-ended high-yield investments, especially in market downturns, because portfolio managers in open-end high-yield bonds or other illiquid assets are forced to sell when there are outflows in down markets and forced to buy when markets bounce back.
“That can destroy a lot of value, whereas your closed-end fund portfolio manager, when everything sells off, he just sits on his permanent capital and doesn’t have to do anything until markets recover,” Jordan says.
For that reason, Dziekanski offers another reason to opt for closed-end fund ETFs over high-yield ETFs: namely, because high-yield ETFs are “not necessarily negatively correlated to equities.”
He says he uses closed-end fund ETFs in a small part of the portfolio, anywhere from 4% to 8% of total allocation. And he says he chooses the funds for their current discounts to historical norms.
Amplify’s Magoon says he sometimes gets pushback from advisors who don’t like closed-end funds at all, mostly because the advisors may have gotten burned by buying the funds at the initial public offering price, which is usually at a premium. The funds are often later discounted, and the closed-end funds in the ETFs are almost always made up of offerings in the secondary market.
In addition, Magoon says, the high fees can turn off advisors. But given the higher yields and lower duration in these funds relative to other fixed-income products, he says some advisors see the higher distribution yield as a trade-off for the higher fees.
“When they see that blend of income and duration, that’s usually when we have a buyer,” Magoon says. “Our biggest reason we don’t sell this to more people is it doesn’t meet their screens for fees.”