Comparing Dividend CEFs With ETFs: Which Are Better?

by: John Dowdee


Dividend CEFs had higher distributions than dividend ETFs but this did not translate into better overall performance.

Dividend CEFs provided more portfolio diversification than dividend ETFs.

Among dividend CEFs, AOD booked the best performance over the periods of the analysis.

As a retiree seeking income, I love dividends and I recently wrote an article on how to choose the best dividend Exchange Traded Funds (ETFs). However, some Closed End Funds (CEFs) also focus on dividends, and CEFs typically have larger distributions than their ETF cousins. Even though high distributions provided excellent income streams, at the end of the day, it is the total return that grows your portfolio. In addition, risk is as important to me as return. So this article compares the "best" ETFs from my previous article with dividend focused CEFs to assess which investment vehicle provided the most reward for a given level of risk.

According to CEFConnect, there are only 7 CEFs that focus exclusively on dividends. To compare performance over a bear-bull cycle, I required the CEFs to have been launched prior to October, 2007 (the start of the 2008 bear market). In addition, I also required a market cap of at least $100 million and an average daily volume of at least 40,000 shares. Note that dividend CEFs are not nearly as liquid as ETFs so limit orders should be used when purchasing CEFs. The following four CEFs satisfied all these criteria.

Cohen & Steers Closed-End Opportunity (NYSE:FOF). This CEF sells at a discount of 9%, which is less than its 52 week average discount of 10%. This fund tries to generate high current income and capital gains by investing in other CEFs. The portfolio consists of 86 investment funds that employ a wide range of investment strategies spread across many different asset classes and sectors. Currently about 86% of the portfolio is composed of securities domiciled in the United States. The fund does not employ leverage and has an expense ratio of 1%. The distribution rate is 7.6%.

Alpine Total Dynamic Dividend (NYSE:AOD). This CEF sells for a discount of 13.4%, which is less than its average discount of 14.9%. The fund has a portfolio of 115 stocks with about half the asset in U.S. stocks and half in foreign securities. The foreign portion of the portfolio is invested primarily in Europe (33%) and Asia (11%). The fund targets under-valued dividend paying stocks. The fund uses a small amount of leverage (less than 1%) and has an expense ratio of 1.2%. The distribution rate is 7.5%.

Alpine Global Dynamic Dividend (NYSE:AGD). This CEF sells at a discount of 10.7%, which is close to its average discount over the past year. The fund has 122 holdings, with about half from the U.S. and half foreign. Similar to its sister fund AOD, AGD has about 35% invested in European companies and 11% in Asian companies. Although the portfolios of AGD and AOD appear similar on the surface, these funds are only 80% correlated with each other. The fund uses only a small amount of leverage (less than 2%) and has an expense ratio of 1.5%. The distribution rate is 7.3%.

Wells Fargo Advantage Global Dividend Opportunity (NYSE:EOD). This CEF sells for a discount of 6%, which is less than its average discount of 9.8%. The portfolio has 96 holdings, spread among equity (66%) and preferred stock (31%). About 58% of the portfolio is domiciled within the United States with most of the rest from European companies. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.5%.

Based on my previous dividend ETF analysis, the following 4 ETFs had the best reward to risk ratios over multiple time frames. For those that did not read my previous article, I have included a summary of some of the pertinent data associated with these ETFs.

Vanguard Dividend Appreciation Index (NYSEARCA:VIG). This is one of the largest dividend ETFs with over $20 billion in assets. The ETF holds 164 firms that have increased their dividend for 10 consecutive years. This fund has an expense ratio of 0.10% and a yield of 2.1%.

iShares Select Dividend (NYSEARCA:DVY). This is the second most popular dividend ETF with assets over $14 billion. This ETF has a portfolio consisting of 100 top dividend payers based on a proprietary screening algorithm. It has an expense ratio of 0.40% and a yield of 3%.

SPDR S&P Dividend ETF (NYSEARCA:SDY). This is the third largest ETF with over $12 billion in assets. This ETF has 97 holdings that have raised dividends for the last 20 consecutive years and then weighs these stocks by their dividend yield. The fund has an expense ratio of 0.35% and a yield of 2.2%.

Vanguard High Dividend Yield Index (NYSEARCA:VYM). This is the fourth largest ETF and has a portfolio of the 391 large-cap stocks that have the highest forecasted dividend yields and weights them by market cap. The fund has an expense ratio of 0.10% and yields 2.7%.

These ETFs generated excellent returns with risks about the same or lower than the S&P 500. It is interesting that these top performers all focused on large-cap stocks domiciled in the United States. As discussed in my previous article, the performance of international and small-cap ETFs typically lagged that of these 4 popular ETFs.

For reference I also included the following ETF in the analysis:

SPDR S&P 500 (SPY). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09% and yields 1.8%. SPY was used to compare the dividend focused funds to the broad stock market.

To compare the performances of the CEFs to the ETFs, 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 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.

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

The plot illustrates that the ETFs and CEFs 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. The fund with the largest distribution (EOD with 8.5% distribution) had the worst risk-adjusted performance.
  2. With the exception of FOF, the CEFs were riskier (had larger volatilities) than the ETFs.
  3. The four CEFs had an average distribution exceeding 7%, much higher than 2.5% yield associated with the four ETFs. However, higher distribution did not translate into higher risk-adjusted returns. Only two of the Closed End Funds (AOD and FOF) held their own when compared with ETFs. The other two CEFs (AGD and EOD) lagged with EOD booking the poorest performance of the group.
  4. For absolute return, AOD was the winner but this CEF was also one of the most risky. In terms of risk-adjusted return, AOD was the best performing CEF and performed better than the S&P 500.
  5. Overall, SDY and VIG had the best risk-adjusted returns with AOD placing a close third.
  6. FOF had a risk-adjusted return the same as the S&P 500 and was grouped closely with the ETFs in terms of both risk and reward.

One of the conclusions from the previous article was that the ETFs were highly correlated with one another. This implied that you did not receive significant diversification by investing in more than one of these ETFs. I now wanted to see if you received more diversification by investing in CEFs. 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 added the SPDR S&P 500 ETF to assess the correlation of the funds with the S&P 500. The results are presented in Figure 2. The CEFs are only moderately correlated (60% to 80%) with ETFs and with each other. The same is true when the CEFs are assessed against the S&P 500. Thus, dividends CEFs do offer significantly more diversification than dividend ETFs.

Figure 2 Correlation matrix over the bear-bull cycle.

Next I wanted to assess if the performance of these funds changed significantly in recent times when the S&P 500 was experiencing a powerful bull market. I re-ran the analysis over the past 3 years from July, 2011 to July, 2014. The results are shown in Figure 3 and what a difference a few years made! During this period, dividend ETFs handily beat the dividend CEFs on both an absolute and a risk-adjusted basis. The CEFs were more volatile and in general did not compensate adequately for this increased risk. Among the CEFs, AOD again had the best performance followed closely by FOF. EOD continued to lag the other CEFs.

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

Finally I wanted to see how these funds had performed over the past 12 months. The results are shown in Figure 4. During this period, most of the dividend funds were tightly bunched around the performance of the S&P 500. With the exception of FOF, the CEFs that were lagging over the previous period made a comeback. EOD redeemed itself and booked performance in the middle of the pack. AOD had the best performance of all the funds (including ETFs). The only real laggard during this period was FOF, which could not keep up with its peers even though it had the lowest volatility.

Figure 4. Risk versus reward over the past 12 months.

Bottom Line

With some notable exceptions, dividend ETFs tended to outperform dividend CEFs over the periods of my analysis. However, CEFs provided more portfolio diversification than ETFs. Among the CEFs, AOD was the top performer. No one knows what the future will hold but if you are an income investor, you should give these CEFs serious consideration as a means to diversify your other dividend holdings.

Disclosure: The author is long VYM, AOD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

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