PCEF: Shrinking Capital And Income

Summary

  • PCEF holds 125 closed-end funds chosen with systematic rules.
  • It has suffered significant capital and distribution decay since inception.
  • Inflation and rising rates will likely be an additional drag in the future.
  • Regarding valuation, its aggregate discount is not attractive.
  • An alternative way to invest in CEFs.
  • Looking for a helping hand in the market? Members of Quantitative Risk & Value get exclusive ideas and guidance to navigate any climate. Learn More »

Pound Coin Stacks

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This ETF review series aims at evaluating products based on price history and current portfolio value and quality. As holdings and metrics change over time, I may update reviews, usually no more than once a year.

PCEF fast facts

The Invesco CEF Income Composite ETF (NYSEARCA:PCEF) is a fund of funds. It tracks the S-Network Composite Closed-End Fund Index. The distribution rate (7.29% as of writing) is very attractive. However, the cost of ownership is high: adding ETF management fees (0.50%) and holdings fees (1.47%), the total expense ratio is 1.97%.

PCEF has 125 holdings screened on several factors. In particular, management fee must be under 1.25% and premium must be under 20%. Weights are based on net asset value and adjusted to favor funds with a discount and penalize those with a premium. Weights are capped at 8%, currently they are all below 5%. The top 10 holdings, listed below, represent 26% of asset value.

Ticker

Name

Weight%

PDI

PIMCO Dynamic Income Fund

4.474

EXG

Eaton Vance Tax-Managed Global Diversified Equity Income Fund

3.306

BDJ

BlackRock Enhanced Equity Dividend Trust

2.617

JPS

Nuveen Preferred & Income Securities Fund

2.498

NFJ

Virtus Dividend, Interest & Premium Strategy Fund

2.36

DSL

DoubleLine Income Solutions Fund

2.318

PDO

PIMCO Dynamic Income Opportunities Fund

2.295

BXMX

Nuveen S&P 500 Buy-Write Income Fund

2.159

ETY

Eaton Vance Tax-Managed Diversified Equity Income Fund

2.006

EVV

Eaton Vance Limited Duration Income Fund

1.965

Source: Invesco

Performance

PCEF has underperformed the S&P 500 (SPY) in total return by a wide margin since inception (February 2010) with deeper drawdowns. It is not the most appropriate benchmark, but total returns matter. Money is money, should it come from dividends or capital gains.

Total Return

Annual Return

Drawdown

Sharpe ratio

Volatility

PCEF

119.25%

6.70%

-41.41%

0.61

11.05%

SPY

409.81%

14.40%

-32.05%

1.01

14.10%

Data calculated with Portfolio123

This table raises a red flag: the annualized return reinvesting all distributions, without paying any tax on them, is a bit below the current distribution rate, and below the historical average (about 7.8%). PCEF pays a high yield and slowly dissolves the principal. The share price has lost 14.6% since inception:

PCEF share price history

PCEF share price history (TradingView on Seeking Alpha)

A perishable income stream

To get the full picture, we must also consider a slowly decreasing income stream in nominal value: the monthly distribution per share was about $0.18 in 2010; it is about $0.13 in 2022 (source: Invesco). It is a 28% decrease. In addition to that, inflation hurts both the invested capital and the income stream’s purchase power. It’s not pretty, and it may get worse. In a rising rate environment, closed-end funds would have increasing leveraging costs and probably decreasing share prices (like most high-yield financial instruments). It may accelerate the loss of capital and income stream in nominal value for PCEF shareholders, and even more in inflation-adjusted value.

Comparing PCEF with a simple benchmark

I wrote in a previous paragraph that SPY is not the best benchmark. Now I will show a good one. The next table compares PCEF since inception with a subset of the closed-end fund universe holding the same number of funds than PCEF: the 125 CEFs with higher yields among those with an average liquidity above $100,000 per day and a positive discount to NAV (net asset value). The subset is rebalanced quarterly in equal weights.

Total Return

Annual Return

Drawdown

Sharpe ratio

Volatility

PCEF

119.25%

6.70%

-41.41%

0.61

11.05%

Reference subset

181.91%

8.94%

-47.23%

0.64

14.36%

Past performance is not a guarantee of future returns. Data Source: Portfolio123

This benchmark, much simpler than PCEF strategy, beats it by a significant margin, with a note of caution: ETF returns are real, the benchmark is hypothetical.

Scanning PCEF portfolio

I looked at two metrics in PCEF holdings:

  • Discount to NAV (negative is bad).
  • Relative discount = Discount to NAV minus its 12-month average (negative is bad).

The fund has 125 holdings, of which 25 have a bad point in these two metrics.

The aggregate discount of the portfolio is inferior to the capital-weighted discount of the full CEF universe (3.5% vs. 6.0%).

The aggregate relative discount is also inferior to the capital-weighted relative discount of the full CEF universe (2.7% vs. 3.1%).

These metrics point to a below-par portfolio value in the CEF universe.

A solution to get high yields without decay

Capital and income decay is a structural issue in many closed-end funds, like in most high-yield instruments. However, it is not inexorable if one knows how to trade CEFs instead of using them as buy-and-hold instruments. I designed a 5-factor ranking system statistically related to forward returns across the full CEF universe, and started publishing the 8 best ranked liquid CEFs in Quantitative Risk & Value (QRV) after the March 2020 market meltdown. The list is updated every week. Its average dividend yield varies around 7-8%. It is not a model portfolio: trading the list every week is too costly in spreads and slippage. Its purpose is finding funds with a good entry point. In the table and chart below I give the hypothetical example of starting a portfolio on 3/25/2020 with my initial “Best 8 Ranked CEFs” list and updating it every 3 months since then, ignoring intermediate updates. Returns are calculated with holdings initially in equal weights without rebalancing until the next 3-month update. Dividends are reinvested at the beginning of every 3-month period.

since 3/25/2020

Total Return

Annual Return

Drawdown

Sharpe ratio

Volatility

Best 8 CEFs quarterly

140.16%

53.83%

-9.84%

2.68

15.70%

PCEF

60.42%

26.16%

-14.62%

1.51

12.53%

SPY

87.71%

36.28%

-14.23%

2.01

Best CEFs list vs. SPY

Best 8 CEFs list vs. SPY (Chart: author: data: Portfolio123)

Past performance is not a guarantee of future return. Data calculated with Portfolio123. Dates and lists can be checked in QRV post history (trial is free).

I don’t expect the “Best 8” list to beat SPY like it did in the past 2 years, but a discount-driven rotational strategy in CEFs has a much better chance to protect both capital and income stream against erosion and inflation than any high-yield passive investment like PCEF.

Takeaway

PCEF selects closed-end funds using a sophisticated rule-based strategy. However, past performance, distribution history and valuation measured in aggregate discount are underwhelming. PCEF may be a useful instrument for tactical allocation, swing trading or capturing some market anomalies, but it doesn’t look like a good buy-and-hold investment for people needing a sustainable income and capital preservation.

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This article was written by

Fred Piard profile picture
14.42K Followers
Data-driven portfolios and risk indicators.
Author of Quantitative Risk & Value and three books, I have been investing in systematic strategies since 2010. I have a PhD in computer science, an MSc in software engineering, an MSc in civil engineering and 30 years of professional experience in various sectors. My aim is making simple and efficient quantitative investing techniques available to my followers. Quantitative models can make investment decisions faster, reproducible and emotionless by focusing on relevant information in the middle of market noise. Moreover, models can be refined to meet specific risk tolerance and objectives. 

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I am an individual investor and an IT professional, not a finance professional. My writings are data analysis and opinions, not investment advice. They may contain inaccurate information, despite all the effort I put in them. Readers are responsible for all consequences of using information included in my work, and are encouraged to do their own research from various sources.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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