Just One ETF: Looking for 3-5% Extra Alpha With Closed-End Fund Income ETF

| About: PowerShares CEF (PCEF)
Several times a week, Seeking Alpha's Jason Aycock asks money managers about their single highest-conviction position - what they would own (or short) if they could choose just one stock or ETF.

Michael Tcheyan is founder of Investment Strategy Advisors, a Summit, N.J.-based RIA. He's a Certified Financial Planner, a CPA, and an adjunct professor for Retirement Planning at Fairleigh Dickinson University.

Before we get to your top investment idea, please tell us a bit about your overall strategy and approach to portfolio management.

My basic underlying belief is that it's almost - not quite, but almost - impossible to reliably and repeatedly predict in advance which asset classes will outperform and underperform over a given time period. On the other hand, it is almost certain that some classes will do better and some will do worse, but that based on history over time the return of each asset class will regress to its mean return.

Thanks to regression to the mean, there is an opportunity to use diversification and tactical allocations to add about 3% to 5% of incremental alpha over a simple buy-and-hold strategy.

What are some of the key elements to your approach?

The main thing is to be well diversified by asset class and take advantage of whatever lack of correlation the markets provide over a given time frame, as well as the impact of "animal spirits" providing P/E expansion and contraction in given asset classes and sectors. The second thing is to avoid the "game over" risk of bankruptcy by sticking with asset and sector classes and avoiding individual stock picks.

By avoiding individual stocks one can have the confidence to add to out-of favor asset classes so as to receive the benefit of outperformance when they recover. Once you have arrived at your risk-based asset allocation, I layer a tactical strategy on top of the portfolio based on trimming positions that are outperforming and adding to positions that are underperforming.

What do you mean when you say risk-based asset allocation? What's the single most important benefit to your approach?

One of the most important aspects of the strategy is to give it time to operate since you can't know in advance which asset classes will do better or worse in given time frames. In other words, since you cant control or predict the market in advance, you need to use regression to the mean to have an idea about the general volatility of specific asset classes - and a certain amount of knowledge about yourself, and your personal attitude to risk and reward - well enough to construct a portfolio that won't cause you to lose sleep at night, or under which you will panic at the end of a bear market and sell at the bottom.

Jeremy Grantham and Richard Bernstein are probably two of the best-known practitioners of this approach, and they have calculated that it will provide approximately 3% to 5% incremental return over a straight buy-and-hold approach.

OK, so tell us: Which single asset class are you most bullish about in the coming year? What ETF position would you choose to best capture that?

Given what I've described, my top pick would be PowerShares CEF Income Composite Portfolio (NYSEARCA:PCEF).

What makes this area your top pick?

Due to its construction, PCEF is a way to implement some of the ideas I mention in a microcosm. PCEF invests in a diversified portfolio of closed-end funds with an emphasis on income generation. The closed-end funds are tilted toward investment and high-yield bond funds as well as income-generating equity portolios which provide an approximate 8% dividend per annum. For starters, this is pretty close to the long-term return of equity benchmarks, so it's an excellent risk-adjusted return.

Add to that the tactical layer of PCEF, which is to prioritize adding positions in closed-end funds selling at a discount and to trim closed-end funds selling at a premium. This allows PCEF to capture some additional alpha based on shifting market momentum and various asset classes going in and out of favor. For this reason PCEF encapsulates many of the advantages of money management that I try and bring to my overall approach.

Are there alternative ETFs that could be used to capture the same theme? What makes this specific ETF your first choice?

There is an alternative ETF - I believe the underwriter is Claymore - but the structure is less efficient, the yield is lower and the assets under management are smaller, making the liquidity less favorable, so I've found PCEF to be the better model.

You mean the Claymore CEF Index Goldman Sachs Connect ETN (NYSEARCA:GCE)? It's got a cap of just $35 million, vs. PCEF's $216 million.

Yes, that's the one.

Does your view differ from the consensus sentiment on this area?

As I've described, I try and avoid a specific view; I hope to take advantage of the fact that a consensus does often emerge, and that's what leads to outperformance or underperformance, and then I try and capitalize on the fact that these periods of out- and underperformance are generally temporary and reverse in a two- to four-year time span.

What could go wrong with your pick?

The biggest risk is not understanding your personal risk/reward tolerance well enough, so that you abandon the strategy at the wrong time. In this regard, this is the same risk one would have with a buy-and-hold strategy.

PCEF chartIt's also conceivable that regression to the mean as we have known it in market history one day stops occurring or - as is happening to a certain extent right now - globalization and computerization of markets continue to such an extent that correlations continue to increase, and the advantages of diversification cease to exist.

Fortunately the industry is good at coming up with new asset classes and investment possibilities so that managers like myself can continue to seek out potential asset classes with less correlation to the market as a whole. And apart from hopefully infrequent events such as the 2008 crash, there will always be a certain amount of non-correlation among the major asset classes of cash, fixed income, equity, and commodities/real estate.

I imagine the other thing that would concern people new to this fund would be the expense - it has 50 basis points on top of the underlying funds' expense, for a total of about 1.8% - but you feel this is made up for by the possible extra income from leaning into discounts?

I think there is some potential upside from the discounting, and you could view it as paying for the investment process, but more relevant to me is that the near 8% yield is after these expenses, and it's the total return that matters to me.

Thanks, Michael, for sharing your choice with us.

Disclosure: Long PCEF.

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