by Paul Weisbruch
No, the title of this article is not the contents of an errant text message from a cell phone of a thirteen year old, but instead it’s actually a headline from last Friday’s market action. Invesco PowerShares debuted PCEF, the CEF Income Composite Portfolio, which based on our experiences and conversations with investment advisors, we believe will gain traction quickly as it's unique in its class.
First and foremost, there exists a segment of investment advisory firms and asset managers that is exclusively focused, or almost exclusively focused, on investing in closed end funds [CEFs]. Similarly, many advisors invest in both CEFs and ETFs, and this unique marriage of the two in the PCEF product certainly deserves consideration by those advisors.
The first CEF was listed in 1893, making them much older vehicles than ETFs. CEFs are initially issued with a fixed number of outstanding shares, so the products are subject to the forces of supply and demand. That said, it is extremely common for a closed end fund to trade at a premium or discount to the fund’s NAV, and many firms base their investment strategies solely on how a fund is trading relative to its NAV, joined with their assessment of the true value of that fund’s underlying securities.
Investors also take into account their expectations of the future performance of the underlying securities in that CEF, and are making a judgment call on the acumen of the fund’s management team when pricing a CEF. If there is a discrepancy between the market price and one’s “valuation call” on the CEF, it makes sense to buy or sell short that CEF, and these forces create the premium / discount dynamic.
Those who are not comfortable in valuing closed end funds now have a professionally managed means of accessing this market through PCEF. This ETF is not simply a random index of closed end funds, but rather there are fairly rigid guidelines on inclusion for the CEFs within the product. S-Network, the index vendor who has partnered with PowerShares on PCEF, screens from a universe of approximately 350 CEFs and has qualitative criteria for a CEF to be included in the ETF.
- First, the CEF must define its investment objective within one of three sectors: taxable fixed income, high yield fixed income, or options income. This gives the investor a pretty clear picture of which asset classes are covered and which style box PCEF will fall into, as the ETF will not contain international equity CEFs like IFN (The India Fund). Thus, transparency is one of the primary criteria.
- Secondly, the CEF must trade on a recognized North American stock exchange that provides a “last closing price,” and also have a minimum capitalization value greater than $100 million. This gives the investor of PCEF fairly solid assurance that the underlying CEFs will be managed by the likes of AllianceBernstein, BlackRock, Eaton Vance, Nuveen, Putnam, and other successful and respected managers. Trading volume in the underlying CEFs is also a qualitative factor in the inclusion formula for PCEF, as the CEF must “have an average daily trading volume of more than $500,000 per day for the three months prior to the rebalancing date.” Those investors who dislike CEFs because they feel they have no visibility over whether the CEF is trading at a steep premium or discount to NAV should feel somewhat better about PCEF, as another part of the criteria for inclusion is that the CEF trades at less than a 20% premium to NAV.
- Finally, the CEF “must have a total expense ratio of less than 2% as of its most recent filing date.”
(Source: PowerShares CEF Income Composite Portfolio Investor’s Guide).
To summarize the factors that S-Network and PowerShares require during their screening process of CEFs for the PCEF product, we list them as:
1. Transparency (clear stated investment objective)
2. Legitimacy (requirement of trading on a recognized North American exchange)
3. Liquidity (minimum average daily trading volume requirement)
4. Pricing Efficiency (exclude those that trade above a certain threshold of premium to NAV)
5. Affordability (ensure that the end investor can reasonably afford the product by capping the expense ratio at 2%)
So in short, the CEF-only crowd should at least take an interest in this professionally managed vehicle to see how it stacks up from their proprietary screening and valuation methods of closed end funds. Perhaps there are investment opportunities for this crowd on not only the long side, but also the short side. And those ETF investors who dabble in some closed end funds but are not completely comfortable with all of the nuances that make CEFs different from ETFs, can also participate in this ETF since it has a formulaic approach in screening the CEF universe and is not just a random basket.
On day 1 of trading, the Street One ETF liquidity desk did receive a handful of inquiries from investment firms that are active in CEFs as well as ETFs in regards to “how PCEF was trading” and “how liquid will this ETF be.” The fund traded over 25,000 shares during the first session and the average bid/ask spread was about 5 cents, which are promising signs, and we priced out the ETF for “size” as well, just to test the waters so to speak.
An investor can establish a fairly large position on the buy or sell side (50k to 100k shares) within a few cents of the bid/ask on the “screen”, and again this was on Day 1 of the ETF’s trading. We suspect that in coming days and weeks as more market participants begin to price and trade the product, it will be even easier to price and trade from a liquidity standpoint. We also stress constantly in our business that “trading volume” is not liquidity, and liquidity is not necessarily trading volume. This ETF may or may not trade millions of shares now or ever, but the underlying components are not terribly hard to price, so this is a relatively liquid ETF.
Also, it’s important to note for those investors who simply do not like CEFs in principle right now and refuse to be involved in the products because of either the premium / discount issues, or perhaps liquidity issues, the fact that PCEF has launched will ultimately help the liquidity of all of the underlying CEFs that are included within the PCEF portfolio. This is because when one trades the PCEF product, the market makers and Authorized Participants that are pricing the underlying will be active in buying and selling those CEFs, creating more volume and activity in the underlying, which should-- over the long term-- make their pricing more efficient and bring in bid/ask spreads on the whole.
Finally, it should be mentioned that due to the inherent nature of this ETF being a “fund of funds,” where the investor can not only assess their valuation of the ETF itself, but of the underlying components which may be trading at premiums or discounts themselves, there is certainly the opportunity to play this ETF from either side of the market, long or short. While PCEF may not be for everyone, it is certainly going to be of interest to CEF-centric investment firms as well as those managers who are ETF focused, but occasionally get their feet wet in CEFs and are looking for a more focused vehicle that can take some of the guess work out of the CEF universe and provide a reliable proxy.
Disclosure: No positions