Income ETFs vs. CEFs

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Includes: AGC, CVY, FFC, HGI, LVL, OLA
by: Chance Carson

Dividend ETFs and high dividend Closed-End Funds have been growing in popularity as conservative investments for retired investors and income investors alike, as they seek to increase portfolio income payouts, reduce market volatility and improve monthly retirement income stability. The question that income investors often ask us at AboutETFs is “Which would be better for me, Exchange-Traded Funds or Closed-End Funds (CEFs)?”

To help answer this question, we turned to Claymore Securities, Inc. for help. Over the past seven years, Claymore has issued approximately $18.4 billion in ETFs, CEFs and Unit Investment Trusts. Claymore’s excellent array of 31 ETFs and 16 CEFs provides us ample data for a simple case study contrasting the differences of dividend-paying ETFs with dividend-paying Closed-End Funds.

Starting with the similarities, both ETFs and CEFs trade like common stocks on major stock exchanges and can be bought and sold anytime during market hours. ETFs and CEFs have minimal portfolio turnover (excluding the new group of actively-managed ETFs; see the related article “Actively-Managed ETFs: What’s the Big Deal?” published on SeekingAlpha) since ETFs and CEFs both track passively-managed indices or groups of sector specific securities. Additionally, ETFs and CEFs can be purchased on margin, can be sold short and can use stops and limit orders. Puts and calls are available for some ETFs.

Closed-End Funds differ from ETFs in one significant regard. CEFs offer the unique advantage of being able to buy shares at a discount to their net asset value [NAV], which substantially boosts an investor’s current income yield. Although there is no single reason that succinctly explains why Closed-End Funds often trade at discounts to their underlying net asset values, there are several factors that may contribute to these discounts. Some of these include investor sentiment, supply and demand for the fund, the fund’s historical performance and its historical yield paid to shareholders.

Seasoned Closed-End Fund investors usually invest in CEFs only when they are trading at significant discounts to their NAV, since every dollar working in the fund (its NAV) is greater than every dollar actually invested at the discounted market price. Generally speaking, the larger the discount at the time of purchase, the higher the current income distribution you will realize.

As of June 30, 2008, the average discount to net value of all U.S. Closed-End Funds was 5.80% compared to the the 10-year average discount of 3.79% (source: Claymore Data and Bloomberg, LP). (An interesting approach for more aggressive investors who wish to actively trade Closed-End Funds is discussed in Richard Lehman’s July, 2008 issue of the ETF Investor Newsletter. Lehman suggests tracking the average discount of your targeted CEF and buying only when its discount reaches an unusually large divergence from its 52-week average discount. Once the CEF's discount has returned back into its “average range,” you would sell, presumably harvesting a capital gain as your CEF’s discount narrows. Lehman lists three CEFs currently trading at more than a 10% divergence from their normal discount.)

Back to our case study, Claymore’s top three yielding ETFs currently sport an average distribution rate of 7.1% (Claymore/BBD High Income Index ETF (NYSEARCA:LVL) 9.9%; Claymore/Zacks Yield Hog ETF (NYSEARCA:CVY) 6.6%; and Claymore/Zacks International Yield Hog Index ETF (NYSEARCA:HGI) 4.7%). In comparison, Claymore’s top three yielding Closed-End Funds are averaging 13.1% (A/C GLB CVT S&I FD (NYSE:AGC) 14.1%; Flaherty & Crumrine/Claymore Preferred (NYSE:FFC) 12.8%; and Old Mutual Claymore Long Short Fund (OLA) 12.5%). The contrast is striking. These three Claymore Closed-End Funds currently distribute nearly 85% more income per year than their ETF counterparts. In addition, these three CEFs offer a discount to their respective NAVs averaging 10.5%.

So what to do? Which is better for you - ETFs or Closed-End Funds? At AboutETFs.com, we feel the best strategy for conservative investors would be to buy both the ETFs and the Closed-End Funds. Why? Very simply, the diversification of six holdings reduces portfolio concentration by half, yet leaves an excellent cross-selection of six high-dividend securities which currently distribute income exceeding 10%. Not bad given today’s vanishing interest rates and reduced dividend yields.

For more ETF and CEF research, here are other excellent websites:

Disclosure: The author/editor holds no positions in the securities mentioned in this article.