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As some of my regular readers certainly know, one of my favorite asset classes to invest in is closed-end funds. This is due to the fact that these entities typically boast very high yields and provide access to a diversified portfolio of companies or other financial assets all in one simple trade. However, these entities have the same problem that stocks do, in that there are a huge number to pick and choose from. Thus, for convenience purposes, it might be easiest to simply invest in a fund of funds that passively tracks an index of closed-end funds just like the SPDR S&P 500 Index ETF (SPY) tracks the performance of the S&P 500. Fortunately, there is such a fund – the Invesco CEF Income Composite Portfolio ETF (PCEF). Over the remainder of this article, we will discuss whether or not this ETF is a good way for an income-seeking investor to play the CEF world in one easy purchase.
About The Fund
As I mentioned in the introduction, the Invesco CEF Income Composite Portfolio ETF is a passively-managed exchange-traded fund that tracks a financial index. This index is the S-Network Composite Closed-End Fund Index. This index does not include all closed-end funds, however, as it only includes funds investing in taxable fixed-income securities, taxable high-yield fixed-income securities, and option-writing income funds. Thus, funds that do regular equity investing, like the Adams Diversified Equity Fund (ADX) or any of the real estate funds, are not included in the index. In addition, those handful of funds that invest in foreign markets are also excluded. The index is approximately evenly split between the three categories of funds that it does track:
Source: PCEF Website
As might be expected by the type of funds that the index includes, the primary objective here is the generation of income. The majority of funds in these three categories are not going to be seeking capital gains as an investment objective. This is not necessarily a problem, but it is something that potential investors do need to keep in mind.
This is immediately obvious if we look at the funds that comprise the index. There are 135 such funds, here are the largest:
Source: PCEF Web Site
As we can clearly see, there is a fairly good mix of funds from each of the major fund houses here. This is likely a good thing since it gives us access to a variety of different management teams, which may have different asset allocation strategies, even among funds in a similar asset class.
As my regular readers on the topic of funds in general likely know, I generally dislike seeing any single position in a fund have a weighting that exceeds 5% of assets. This is because this is approximately the level at which a position begins to expose the fund to idiosyncratic risk. Idiosyncratic risk is the risk that any asset has that is independent of the market as a whole. Thus, what could happen is that the price of one of the closed-end funds in the index could decline when the overall market does not, and if that fund has too high of a weighting, then it could drag down the value of the overall portfolio. As we can see here, though, there are no funds in the index that have a weighting approaching 5% so it appears that this is not a problem here.
Performance
As roughly two-thirds of PCEF consists of fixed-income and the remainder consists of option-income funds, one might expect the ETF to underperform common equity as these asset classes typically do. This is indeed the case as the ETF has consistently underperformed the S&P 500 index over just about any trading period:
Source: PCEF Web Site
We can also see in the above chart that PCEF has consistently underperformed its index. This is due to its 0.50% expense ratio, which is a bit on the high side for an exchange-traded fund. ETFs always underperform their indices due to the expenses of the fund and this one is no exception.
We do see here that the fund has consistently delivered a positive return to its investors. This is something that we like to see with an income fund as these funds are usually used by those investors that are seeking protection of capital as well as a return.
One of the defining features of closed-end funds is that their prices tend to be relatively flat in normal market conditions. This is due to the fact that these funds typically pay out all interest income and capital gains to their investors in the form of distributions. Thus, the fund is normally managed so that the fund’s net asset value tends to stay around the same level. As might be expected then, PCEF typically sees its price sit around the same level:
Thus, investors in the fund should expect the overwhelming majority of their total returns to come in the form of distributions. This is also not really a problem, particularly for those holding their position in the fund in an IRA or similar tax-advantaged account, but it is something that you should keep in mind.
Commentary On The Fixed-Income Market
There were a few times last year that I advised investors to avoid fixed-income securities. The rationale behind this decision was that the Federal Reserve had finally begun hiking rates in earnest after a decade of essentially zero percent interest. One of the defining characteristics of fixed-income securities is that their prices move inversely to interest rates due to the fact that nobody will want to buy an older bond with a lower coupon rate when you can get a newly issued one with a higher rate. Therefore, the price of the older bond must decline (thus pushing up the yield) to a price where the bond offers the same effective rate as a newly issued bond.
However, that thesis changed a few months ago. As I discussed in a previous article, the Federal Reserve will not be doing any rate hikes in 2019, and given some of the macroeconomic trends that are pointing to a weakening economy, it seems likely that the central bank may be more likely to cut rates rather than increase them in 2020. This is generally a positive for fixed-income securities as rate cuts would point to them increasing in price. In addition, bonds and other fixed-income securities typically hold up better than stocks in periods of economic weakness since they are higher up in a company’s capital stack. Thus, investing in fixed-income or fixed-income funds may be a good idea.
With that said, though, there would certainly be some risks here, particularly due to the fact that about a third of PCEF’s portfolio is invested in high-yield closed-end funds. High-yield bonds are much more susceptible to the economic cycle than investment grade bonds are. This is due to the fact that most of the companies issuing these bonds are highly levered entities that have a high risk of default. These types of companies are far more likely to go under should the economic environment weaken than a more conservatively financed entity. The higher yield that these bonds have is due to this high risk of default, but of course, you do not get anything if the company goes under.
Distributions
As already mentioned, PCEF’s underlying index is focused only on closed-end funds that have the objective of the generation of income. In addition, fixed-income closed-end funds typically use leverage to enhance the yield that they are able to generate for their investors. As such, we might expect PCEF to boast a relatively high yield. This is indeed the case as the fund currently boasts a trailing distribution yield of 7.38%, which is one of the highest in the ETF space. However, as is commonly the case with exchange-traded funds, this distributions tends to vary over time:
Source: NASDAQ
The reason for the fluctuating distribution is that the outstanding share count of exchange-traded funds is always changing, so naturally, this results in a different amount of shares that need to receive the distribution when each ex-distribution date rolls around.
One thing that we do do see here is that PCEF pays out its distribution on a monthly basis. This is something else that is nice to see as it allows for faster compounding if you are reinvesting the distribution since you will have more shares every month that are eligible to receive distributions. Those individuals that are only investing in the fund to receive income will also like the regular monthly schedule since bills are generally paid monthly, so the money will be hitting your account as you need it.
Conclusion
In conclusion, PCEF is certainly an interesting ETF since it is one of the few true fund of funds in the space. It may be a decent choice for income hunters, although the exposure to high-yield bonds does expose it to a certain amount of risk in the current economic environment. The fund is also one of the few ETFs that pays a monthly distribution, which some should appreciate.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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