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Invesco PowerShares launched the first ETF whose portfolio consists of closed-end funds last month. The PowerShares CEF Income Composite Portfolio (NYSEARCA:PCEF) tracks the S-Network Composite Closed-End Fund Index.

Like mutual funds and ETFs, closed-end funds are diversified portfolios, but they differ in the way they sell and price their shares. Mutual funds and ETFs are open-end funds because they can sell as many shares needed to satisfy investor demand. In addition, they’re priced each night at their net asset value, or NAV. However, a closed-end fund sells a limited number of shares on the stock exchange in an initial public offering. Because closed-end fund shares trade on the stock exchange, demand for the shares determines price not the NAV. Thus, most closed-end funds sell at a discount or premium to the fund’s NAV.

PCEF is a “fund of funds,” as it invests its assets in the common shares of funds included in the underlying index. The index selects constituents from a universe of 350 U.S. closed-end funds with a concentration in one of three sectors: taxable fixed income, which includes corporate bonds, government bonds and mortgage back securities; high-yield emerging market debt and bank loans, and option-income funds. Unique to close-end funds, option-income funds buy high dividend yield equities and sell options to create high current income.

The fund of funds concept is an interesting one. Essentially, the fund sponsor says there are a lot of great funds out there and we’re going to give you one-stop shopping and create a portfolio of the best so you don’t have to do the research. Since the cost of buying many closed-end funds would be huge, you get the ETF benefit of diversification within a minimal investment. But since, each closed-end fund is already a diversified portfolio, how many does one investor really need?

The key advantage to this kind of ETF is dividend yield, which can get pretty sizeable with closed-end funds.

“PowerShares wanted high maximum current yield and to be well diversified,” says Paul Mazzilli, senior advisor to S-Networks Global Indices. “Because ETFs invest in the most liquid high-yield bonds, they don’t have the highest yield, but do have significant tracking error. Since, closed-end funds can hold illiquid securities, high-yield closed-end funds will have a higher yield than high-yield ETFs.”

Dividends and yield have become hot topics as people look for some guaranteed returns in a market full of uncertainty. Yield is the rate of return you receive from the dividend. While the dollar amount of the dividend payment remains the same, yield moves daily in an inverse relationship to price. When the share price of a closed-end fund falls, the yield percentage rises. When prices rise, yield falls. Currently, the index has a composite yield of 8.66%, which is double the 10-year Treasury note.

Up to now investors have had only one choice it they wanted to track closed-end funds in an exchange-traded product. Two years ago, the Claymore CEF GS Connect ETN (NYSEARCA:GCE) launched. Unlike PCEF, which actually holds closed-end funds, GCE is an exchange-traded note, an unsecured subordinated debt instrument that promises to pay the index’s return without actually holding assets. The GCE currently yields 8.3%, but since it has not funds, it receives no dividend, so their are no payouts. The yield is merely factored into the total return of the index. With only $3 million in assets under management, it hasn’t garnered much enthusiasm.

One especially nice thing about PCEF is that dividends are paid out monthly. This ETF expects to go ex-dividend on March 15, which means you need to buy before then to get this month’s payout.

Currently, the index holds 71 closed-end funds, of which 27 invest primarily in taxable investment-grade fixed-income securities, 15 invest primarily in high-yield fixed-income securities and 29 primarily use an equity option writing (selling) strategy. The index bases its weightings on a value-based rules approach, instead of market-capitalization. Market-cap weightings give additional weight to richly valued funds and underweight the undervalued funds, which is the opposite of what an investor wants.

“During the quarterly index rebalancing, we look at the average discount of all the funds,” says Mazzilli. “The funds with a wider discount get their weighting increased, while the funds with as wider premium get their weight decreased. Like fundamental indexing, the index focuses on value, selling the expensive funds and buying the cheaper funds.”

This approach enhances the fund’s return because it’s focused on securing the highest yield over price appreciation. It addition, you avoid capital gains inside the fund because closed-end funds and ETF’s have more tax efficient structures than mutual funds.

However, there are some serious negatives here. High yields are not just a function of shares being discounted, but typically signify a higher level of risk in the underlying securities, especially high-yield emerging market debt. The multiple layers of diversification within the closed-end funds and the ETF itself should lower that risk. However, closed-end funds have the transparency requirements of mutual funds. They only need to tell you what they own every six months. So, you never really know the level of risk of each fund’s holdings.

Then there’s the cost. While PCEF charges an expense ratio of 0.5%, a reasonable rate, each closed-end fund in the ETF also charges an expense ratio which will be paid out of the underlying funds. And while the ETF won’t hold any funds with an expense ratio higher than 2%, this duplicate level of fees significantly increases the cost of the investment and it’s not specified by how much, but it looks like 1.8%.

Dave Nadig of IndexUniverse calls it “the worst of all possible worlds – zero transparency, high costs, and unreliable pricing.” I’m not sure I would go that far, but I am concerned by the fact that PowerShares hasn’t posted a factsheet yet on the fund.

In the comments section, Mazzilli debates Nadig over the funds transparency, pointing to the white paper detailing the fund’s workings. In addition, on the S-Network Web site you can find the constituent list for the index as of Dec. 31, 2009, which would have been the holdings when the fund launched. You can also find the fund holdings on the PowerShares Web site. You could make the effort to find out what the closed-end funds hold, but that’s a layer of research the ETF tries to help you avoid.

Personally, I like the idea of a high-yielding investment that pays monthly. But I’ve always been bothered by the duplicate level of fees found in every fund of funds product and how it will take a significant bite out of that dividend payment. The big benefit seems to be the ability to invest in closed-end funds with a much lower level of risk than you would have when you put a lot of money in a single fund.

Disclosure: No position

Source: Weighing the Pros and Cons of PowerShares New Closed-End Fund ETF