By Mike Taggart, CFA

Given the persistent low interest rates, many investors are seeking ways to increase their portfolios’ income generation. Closed-end funds can help in this regard for two principal reasons. First, because CEFs trade intraday on a stock exchange, their prices can deviate from their underlying net asset values by trading at discounts or premiums. If a fund offers a 10% distribution rate computed at NAV, investors can realize more than 10% if they can buy the fund at a discount to NAV. Second, many CEFs employ leverage, which the 1940 Investment Company Act prohibits for open-end mutual funds and exchange-traded funds; when used properly, leverage can benefit the performance and distribution rate of CEFs.

However, because CEFs are largely misunderstood in the marketplace, investors often shy away from investing in them. A fund’s discount or premium to NAV can increase investor uncertainty. The distribution rate may include return of capital, which can render the published yield misleading. Leveraging a portfolio not only provides potential upside reward but also heightens volatility. Such concerns (and we’ve only scratched the surface) can offset any potential investor interest that the higher potential income generation of CEFs provides, causing investors to seek income from other, more stable sources.

PowerShares Closed-End Fund Income Composite ETF

What It Is:

A way to gain access to a basket of closed-end funds: PCEF aims to mimic the return and income performance of its underlying benchmark, the S-Network Composite Closed-End Fund Index. This index includes only CEFs invested in taxable investment-grade fixed income, taxable high-yield fixed income, and equity option income strategies. Rebalanced quarterly, the index excludes funds that do not have enough trading volume, that are trading above a 20% premium to NAV, and that have total expense ratios above 2%. The index currently contains 82 funds. Because of the index’s construction, PCEF can provide investors with CEF diversification and income enhancement in one trade.

A vehicle for income enhancement: To take advantage of the pricing inefficiencies (discounts and premiums) inherent in CEF investing, the index is weighted more heavily toward component funds that are trading at discounts to underlying NAV. This naturally increases the distribution rate (commonly referred to as yield). For instance, if a fund with a $10 NAV can generate $1 of distributable income, that’s a 10% distribution rate; if the same fund is purchased at $9, that $1 of distributed income becomes 11% for investors. PCEF currently sports a distribution rate (yield) of about 8.3%, significantly higher than equity index or long-dated corporate- and government-bond yields. In effect, because of the underlying structure of its benchmark, PCEF is set up to be an income-producing machine that should continue to provide distribution rates that are competitive with or even higher than those of single-asset class investments.

What It Is Not:

A way to eliminate price inefficiencies in CEFs: As mentioned, closed-end funds typically trade independently of their underlying net asset value. The heavier weighting of discounted funds in the S-Network Index and PCEF does not mean that those funds will not continue to trade at a discount or that their discounts will not widen. Discounts to NAV often increase significantly in times of severe market turbulence. For instance, in late 2008, the average discount across the entire CEF universe gapped to nearly 17%, whereas the long-term historic average at the time was closer to 4%. While the fund is structured to capture income enhancement, there is no guarantee that its net asset value will not fall if the underlying CEFs’ discounts widen or NAVs decline.

A low-cost method of CEF investing: Like other types of funds, CEFs carry expense ratios and trading costs. Aggregating these into a portfolio of CEFs does not eliminate any costs and actually adds the cost of running the ETF. As an investor, PCEF needs to pay the underlying funds’ expense ratios, which it passes on to its own investors. The aggregate expense ratio for the underlying funds is now about 130 basis points. On top of this, PCEF adds another 50 basis points for its own efforts managing the portfolio, which brings PCEF’s total expense ratio to roughly 180 basis points. PCEF investors also pay for trading that comes about with the quarterly index rebalancing. Still, a 50-basis-point expense ratio seems reasonable for this ETF, and investors who invest directly in the funds would incur the underlying expenses anyway.

An easier way to meet tax obligations from CEF distributions: As with individual CEFs, investors should note that the underlying holdings of PCEF will make distributions that may consist of ordinary income, dividends, long- and short-term capital gains, and return of capital. These items will retain their tax characteristics and will be passed to PCEF investors via distributions. Come tax time, investors will still need to properly break down their distributions into the appropriate categories (and to alter their investment cost basis in the case of returns of capital) in order to correctly file their taxes.

Overall, we believe that this fund can capture the income-enhancing benefits of CEFs while eliminating many CEF nuances that confound prospective investors. Those weary of low-yielding bond and equity holdings may find PCEF a refreshing alternative.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (( BGI )), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.