Over the past year it has become more evident to me that there is a universal truth amongst individual investors that to achieve their goal quicker, all they need to do is stack on the risk. The majority of the clients I work with seek income from their portfolios, and with interest rates at current levels, tracking a lower than average duration mix of bonds, can be like watching paint dry. Investors want their baseline goal achieved, and their capital preserved when volatility gets unwieldy, but most importantly they want the opportunity to outperform their own needs or expectations. An investor that needs just 4% to live on from their portfolio can more than likely achieve their goal with a professionally managed basket of fixed-income, but there isn't much hope to do better. My philosophical belief is that a well managed and integrated closed-end fund [CEF] sleeve within an actively managed fixed-income portfolio can ultimately produce an excellent yield and total return enhancement. It's the unique pairing of the solid-state safety and reliability of open-end fund [OEF] and ETF fixed-income vehicles alongside the calculated risk of leveraged CEF opportunities that can provide just the right amount of upside potential.
My 80/20 Rule
Since the majority of the CEF market is geared toward fixed-income strategies, that's where I recommend investors begin to focus their efforts. Now that you have developed your own personalized selection criteria and watchlist from reading Part 1 and Part 2 of this series, you can begin integrating those picks into your portfolio. Before purchasing a CEF I stress that you do some real soul searching to identify how much volatility you can actually stomach. Your own tolerance may be less than mine, or more than mine, you just need to understand the eventual influence your decision will have on your future returns. The 80/20 rule I developed acts as a baseline for most clients I work with, here is how it works. For the sake of round numbers, let's say your entire portfolio is $500,000 with an asset allocation split of roughly 40% equities, and 60% fixed-income. I would isolate the fixed-income sleeve of the portfolio, which would total $300,000, then split it so that 80% stays allocated toward traditional OE and ETF fixed-income investments priced at/near NAV. Then the other 20%, or $60,000, would be allocated to a dedicated actively managed CEF sleeve. Then I would divide that sleeve into 4-6 individual CEF positions, that way you are still keeping some level of diversification. I have found that a mix of assets like this provides for just the right amount of risk vs. reward that would satisfy an average investor's goals and objectives.
Working in Concert
As I have mentioned in my prior articles, I am a big proponent of focusing your research efforts on a handful of CEFs you would like to integrate into your portfolio. A strategy that I find very effective is intermingling a CEF with its OEF counterpart. The basis for this methodology is that you can own a more conservatively managed OEF with a larger slice of your portfolio, and then pair it alongside an aggressively managed and leveraged CEF with both investments run by the same portfolio management team. That way you are focusing the entirety of your fixed-income sleeve to a just a few particular themes or sectors, and thereby not stretching your ongoing analytical bandwidth to thin. An excellent example of this strategy would be pairing the PIMCO Income Fund (PIMIX) with its CEF cousin the PIMCO Dynamic Income Fund (NYSE:PDI) I discussed in part 2. In a chart below I have PIMIX and PDI's NAV in a performance comparison.
You can see just how effective this strategy can be with both funds posting very impressive returns. However, the more conservatively managed PIMIX acts as a core position and PDI as a strategic total return enhancement position. If ever you feel the CEF side of the equation has reached a premium that doesn't warrant as large a commitment, you can always reduce or remove your holding while still maintaining exposure to the core strategy. The true alpha potential lies in the expanding or collapsing of the CEF sleeve at high probability points in time.
No matter how you decide to integrate or even alter the CEF approach I have laid forth in this series, keep in mind that risk management is paramount. What worked yesterday may not always work tomorrow, and it will be the ongoing research you conduct that will ultimately yield the most favorable results. It's difficult to convey an all encompassing portfolio management strategy in just three articles. However, my purpose was to convey to investors that have used CEFs in the past with not much success, that there are a few baselines that can drastically assist you in your future investment endeavors.
Additional disclosure: Fabian Capital Management, and/or its clients may hold positions in the ETFs or mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.