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PowerShares, the Chicago-based ETF issuer behind many enhanced index ETF products, announced on Friday the launch of the industry’s first ETF portfolio of closed end funds. The PowerShares CEF Income Composite Portfolio (PCEF) is linked to the S-Network Composite Closed-End Fund Index, a rules-based index designed to track the overall performance of a global universe of U.S.-listed closed-end funds. The index currently includes 71 closed-end funds, including 27 that invest primarily in taxable investment-grade fixed-income securities, 15 investing primarily in high-yield fixed-income securities, and 29 utilizing an equity option writing strategy.

In order to be included in the underlying index, closed-end funds must focus on taxable fixed income, high-yield fixed income, or option income. Eligible funds must also trade at a premium to net asset value of less than 20% and have a total expense ratio of less than 2%. The methodology behind the underlying index is somewhat interesting in that it is designed to take advantage of inefficiencies in the CEF market by assigning greater weights to funds trading at a discount while reducing exposure to those trading at a premium.

CEFs 101

Closed-end funds are professionally managed investment companies that are publicly-listed and traded on a stock exchange. Capital raised during an IPO is used to achieve a specific investment purpose, such as current income or capital growth. At the end of 2009, there were more than 600 closed-end funds with $200 billion in assets.

Because closed-end funds don’t feature the arbitrage mechanisms underlying ETFs, they often trade at a discount to the underlying net asset value. According to Morningstar, almost 75% of U.S.-listed CEFs were trading at a discount at the end of 2009, with the average discount to NAV across all CEFs equaling 4.2%. As such CEFs provide the potential to achieve a distribution rate higher than what could be offered by an investment directly in the underlying assets of the fund, as illustrated in the adjacent example.

According to the PowerShares Web site, PCEF exhibits an average discount to NAV of about 3.6%.

PCEF is the first ETF of its kind, but the unique exposure comes at a relatively steep price. PCEF charges just 0.50%, but because it is structured as a “fund of funds,” acquired fund fees and expenses bump the total annual fund operating expenses to about 1.81%.

Disclosure: No positions at time of writing.

Source: PowerShares Launches Closed-End Fund ETF