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  • The Sleep Soundly CEF Portfolio has generated greater return with lower risk than the S&P 500 over the bear-bull cycle beginning in 2007.
  • The Sleep Soundly CEF Portfolio outperformed the S&P 500 on a risk-adjusted basis for all time frames analyzed since 2007.
  • The Sleep Soundly Portfolio provides over 7.5% income and still allows me to sleep soundly each night.

The market has been on a tear since it bottomed in 2009, rising almost 200%. It is now the 4th longest bull market since the Great Depression and it still doesn't show signs of slowing down. I have no idea what the future may hold but as a retiree, I am beginning to worry. I do not have time to recoup from devastating losses like many suffered in the 2008 bear market. Thus, even though I may limit my potential upside, I have decided to move my portfolio into a more defensive position that will allow me to "sleep soundly" each night.

As an income focused investor, I'm a fan of Closed End Funds (CEFs) and have written many articles on Seeking Alpha discussing the risk versus reward of different asset classes. For this article, I selected one CEF from ten different asset classes to construct a portfolio that I hoped would minimize risks while returning an adequate reward. I chose only funds that had been in existence during the 2008 bear market so that I could judge performance over a complete bear-bull cycle. The CEFs that I picked are summarized below.

Gabelli Equity Trust (GAB): I wanted to have one pure equity play in my portfolio since the overall market has been extremely strong and I wanted to capture some of the upside potential if the bull continued to run. Due to its first-class performance, this CEF sells at a premium of 3.3% which is a little below its average premium of 4.6%. This fund utilizes a strict value methodology and has been managed by the founder, Mario Gabelli, since its inception in 1986. Mr. Gabelli also owns, directly or indirectly, about 1.6 million shares of the fund. The fund has 403 holdings, with about 82% invested in North America and the rest primarily in Europe. It uses 20% leverage and has an expense ratio of 1.4%. The distribution rate is 8%, which is funded by income, realized capital gains, and Return of Capital (ROC). The ROC is not considered destructive since it comes primarily from unrealized capital gains.

John Hancock Premium Dividend Fund (PDT). Preferred stock funds are generally less volatile than their common stock cousins. As long as interest rates are low, preferred stocks should perform well. This John Hancock fund contains 70% preferred stock with the remainder of the portfolio invested in dividend-paying equities. It sells at a discount of over 11% (which is about the same as the average 52-week discount). The fund has a distribution of 7.2%, none of which comes from ROC. It has over 100 holdings, with the utility sector accounting for almost half of the total assets. The fund uses 34% leverage and has an expense ratio of 1.8% (including interest payments).

Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV). Covered call (also called buy-write) funds sell options to enhance their return. This should provide some protection in a down market while delivering reasonable appreciation when the market moves higher. This CEF sells at a small premium of 0.7%, which is different than its average discount of 4%. This is a large fund with 208 holdings, all from the United States. About 60% of the holdings are from S&P 500 stocks and the other 40% are from NASDAQ stocks. The name "tax-managed" means that the fund managers try to minimize the tax burden by periodically selling stocks that have incurred losses and replacing them with similar holdings. This strategy has the effect of reducing or delaying taxable gains. The fund writes options on 84% of the portfolio. The fund does not use leverage and has an expense ratio of 1.1%. The current distribution is 8.8%, funded primarily by non-destructive ROC.

Cohen and Steers REIT and Preferred Fund (RNP). Historically, Real Estate Investment Trusts (REITs) have been a favorite asset class for income oriented investors. REITs were hit hard in the 2008 bear market, but have rebounded strongly along with other equities since 2009. One of the reasons REITs are so popular is that they receive special tax treatment and as a result, are required to distribute at least 90% of their taxable income each year. This CEF has 201 holdings consisting of a combination of both REITs (51%) and preferred stocks (47%). It currently sells for a discount of 12.3%, which is less than its average discount of 13.1%. The fund uses 29% leverage and has an expense ratio of 1.8%, including interest payments. The distribution is 7.2%, consisting primarily of income with about 20% non-destructive ROC.

Kayne Anderson MLP Investment (KYN). Master Limited Partnerships (MLPs) are a unique asset class known for their high yields. Like REITs, MLPs must distribute 90% of their income. Most MLPs operate in the "midstream" portion of the energy production cycle which involves the storing, transporting, or processing of energy (as opposed to "upstream" exploration or "downstream" retail sales). Therefore, they are relatively insensitive to many of the economic forces that affect other assets. This CEF is structured as a C-corporation and sells for a premium of 1.6%, which is small compared to its average premium of 5.5%. It holds 71 MLP securities and uses 32% leverage. The expense ratio is 2.6%, including interest. The distribution is 6.1% consisting of income and non-destructive ROC.

PIMCO Income Opportunity Fund (PKO). This is a go-anywhere income fund that has the flexibility to build a portfolio consisting of PIMCO's best ideas, including global bonds, bank loans, and sovereign debt. This CEF sells at a small discount of 0.8%, which is close to its average discount of 0.3%. Over a 5-year period, this fund has averaged a premium of 3.8%, but has been oscillating around the zero premium line since the middle of last year. This fund has $562 million in assets and is managed by Dan Ivascyn. The portfolio has 476 holdings, allocated primarily among asset-backed bonds (49%), corporate bonds (33%) and government bonds (16%). Only about 30% of the holdings are investment grade. The fund utilizes 38% leverage and has an expense ratio of 1.9%. The distribution is 7.9%, with no ROC.

Western Asset Emerging Markets Debt Fund (ESD). Emerging markets refer to securities domiciled in a country that is considered to be emerging from an under-developed economy to a more mainstream environment. I selected an emerging market bonds fund for the portfolio because 1) they generally offer higher yields than comparable bonds from developed countries and 2) because the prices of these bonds rise and fall due to local conditions, which may not be in sync with U.S. markets. This CEF sells at a discount of 9.2%, which is less than its average discount of 10.3%. It has 199 holdings with about 50% in sovereign debt and 44% in corporate bonds. The assets are distributed among several countries, including Mexico (9%), Turkey (8%), Indonesia (8%), Venezuela (7%), Russia (7%), and Brazil (7%). The fund uses only 8% leverage and has an expense ratio of 1%. This distribution rate is 7.6% with no ROC.

Invesco Credit Opportunities Fund (VTA). This fund invests in floating-rate loans from both the U.S. (about 60%) and Europe (40%). This provides the portfolio with a hedge against rising rates since the interest rates associated with floating-rate loans are adjustable. This CEF sells for a discount of 7.5%, which is larger than the average discount of 6.6%. It has a distribution of 7%, none of which was ROC. The fund has 549 holdings, with 78% in floating-rate loans and the rest primarily in high-yield corporate bonds. VTA utilizes 31% leverage and has an expense ratio of 2.2%, including interest payments

Calamos Convertible Opportunities and Income Fund (CHI). A "convertible security" is an investment, usually a bond or preferred stock, that can be converted into a company's common stock. The attraction of convertible CEFs is that they offer upside potential with some protection on the downside. This CEF sells for a premium of 1.5%, which is higher than its average premium of 0.3%. The fund has 280 holdings with 61% in convertibles and the 36% in corporate bonds (mostly high yield). The fund utilizes 28% leverage and has an expense ratio of 1.5%. The distribution is 8.2%, comprised of income and non-destructive return of capital.

Western Asset High Income Opportunities Fund (NYSE:HIO). This fund invests in "high yield" or "junk" bonds. These are bonds that have been rated "below investment grade" by the bond rating agencies. As the name implies, these bonds offer higher yields due to their increased risk of default. In addition to sensitivity to interest rates, high yield bonds prices also follow the ups and downs of the economic cycles (similar to equities). This fund sells at an 8.2% discount, which is larger than its average discount of 7.5%. The distribution rate is 7.2% with no ROC. The fund has 390 holdings, most of which are high yield bonds rated between BB and CCC. This is a global fund with only 5% of the holding domiciled within the USA. This fund does not use leverage and has a low expense rate of 0.9%.

Sleep Soundly Portfolio

If you equal weight each of the selected CEFs, the resulting portfolio has an average distribution of over 7.5% so it certainly meets my criteria for high income. I named this portfolio the Sleep Soundly Portfolio for reasons that will become apparent from my analysis. It should be noted that this portfolio has about 50% equities (assuming REITs and MLP are categorized as equities) and 50% fixed income. Therefore, you might expect that the portfolio's volatility and return would be significantly less than the S&P 500. To determine if this expectation was borne out by the data, I included the following S&P 500 Exchange Traded Fund (ETF) as my benchmark:

SPDR S&P 500 (NYSEARCA:SPY). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09% and yields 1.8%.

To assess the performance of the Sleep Soundly Portfolio, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds from October 12, 2007 (the market high before the bear market collapse) until today. The Smartfolio 3 program was used to generate this plot that is shown in Figure 1.

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Figure 1. Risk versus reward over the bear-bull cycle.

The plot illustrates that the CEF components have booked a wide range of returns and volatilities since 2007. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY.

Some interesting observations are evident from the figure.

  1. Over the complete cycle, most of the selected CEFs were volatile, but also provided high returns resulting in a risk-adjusted performance that handily beat the S&P 500.
  2. The bond CEFs (VTA, ESD, HIO, and PKO) were the least volatile. PKO had the best performance beating the S&P 500 on both an absolute and risk-adjusted basis. The convertible CEF was more volatile than SPY and lagged in risk-adjusted performance
  3. The three most volatile CEFs (KYN, GAB, and RNP) also had high returns resulting in a risk-adjusted performance better than SPY.
  4. On a risk-adjusted basis, the best performing CEFs in order were PKO, PDT, KYN, and ETV

I then combined these 10 CEFs into an equally weighted Sleep Soundly Portfolio and assessed how the combined portfolio performed. The risk versus reward of the combined portfolio is shown as a "blue dot" on the figure. As you can see, the combined portfolio had a volatility that was less than most of the constituent volatilities. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. The key to constructing such a portfolio was to select components that were not highly correlated with one another. In other words, the more diversified the portfolio, the more potential volatility reduction you can receive.

To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. I also included SPY to assess the correlation of the funds with the S&P 500. The data is presented in Figure 2. The covered call fund, the REIT fund, and the equity fund were all moderately correlated with the S&P 500. The other CEFs were much less correlated with SPY. Among the CEFs, all the correlations were relatively small (in the 40% to 60% range). These results are consistent with a well-diversified portfolio.

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Figure 2. Correlation matrix over the bear-bull cycle.

My next step was to assess this portfolio over a shorter timeframe when the S&P 500 was in a strong bull market. I chose a look-back period of 5 years, from August 2009 to the present. The data is shown in Figure 3 and as you might anticipate, during this bull market period, the SPY outperformed most of the CEFs. Only 4 funds (PKO, PDT, KTN, and RNP) were able to keep pace with SPY on a risk-adjusted basis. However, all the other CEFs were "close" to SPY in performance, resulting in a portfolio that had a return comparable to SPY, but with volatility about 24% less than the SPY. Thus, I was pleased with the performance of the portfolio during this bull market period.

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Figure 3. Risk versus reward over the past 5 years.

I then shortened the look-back period to 3 years (August 2011 to the present) to see if the relative performances changed. The results are presented in Figure 4 and are still impressive. As the bull picked up steam, the SPY moved into the lead against all the CEFs except for ETV, which booked comparable results. The individual components continued to be volatile but the portfolio had volatility about 30% less than SPY. It is true that the portfolio gave up some absolute return with respect to the S&P 500 but it was also safer. On a risk-adjusted basis, the portfolio slightly beat the S&P 500.

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Figure 4. Risk versus reward over the past 3 years.

My last test of the portfolio was to see how it has performed over the past 12 months, as the S&P 500 made new-high after new-high. The results are shown in Figure 5 and are still excellent. Some of the CEFs (PKO, PDT, ETV, and RNO) actually outperformed the SPY. Overall, the portfolio held its own, providing a return a little less than SPY with a much reduced volatility. Again, on a risk-adjusted basis, the portfolio easily beat the SPY.

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Figure 5. Risk versus reward over the past 12 months

Bottom Line

I am happy with this portfolio and have personally invested in it, but each investor must assess if it meets their risk profile and investment objectives. I make no forecast as to how this portfolio might perform in the future and I do not claim that the Sleep Soundly Portfolio is the best portfolio that can be constructed with CEFs. I put this portfolio together based on my experience with CEFs, but other investors might do better using different selections and different weights. If readers have better selections or different criteria, I welcome comments. All I can say with certainty is that this portfolio allows me to sleep soundly each night.

Source: A High Income 'Sleep Soundly' CEF Portfolio