CEFs offer the higher, juiced up distributions. We call them distributions because this more correctly classifies them. The source of "dividends" comes from more than just income, it can come from; income, capital gains or a return of capital. Return of capital isn't always bad either, as we have delved into in the past.
Another reason CEFs can offer more monthly or quarterly income is for the fact that they can use more complex strategies. This can include the utilization of leverage or options strategies. Both of these strategies can potentially enhance returns, or even potentially mitigate drawdowns - in the case of options being used. These strategies do involve a more actively managed portfolio. This involves investment managers running the fund day to day. That also increases costs for the fund to operate, increasing their expense ratios.
This is exactly where CEFs can fill a role though in your transition to retirement; they can make sense in any one's portfolio as a way to juice yields overall. The average distribution rate for all CEFs as of July 3rd is 7.95% (using CEFConnect's data.) This is much higher than we would see for individual stocks and even higher than the typical ETF.
Of course, there are dangers, just like any other investment vehicle. In the case of CEFs, two specific dangers exist. The use of leverage in a downturn can amplify the drawdowns in sharp sell-offs. This is exactly what we see time and time again. Another 'danger' in CEFs is the fact that they can trade at premiums and discounts. This isn't so much of a danger, as it is an opportunity for vigilant investors to get some excellent entry prices.
With almost 7000 ETFs worldwide in 2019, there are certainly a few out there to meet an investor's specific and unique needs. These are generally a passive way to invest, although there are more and more active ETFs coming to market it seems. This passive nature can cause expenses to drop significantly. However, the passive nature of these investments can also result in some strange and unfortunate manners. Juan de la Hoz and I briefly discussed this in a recent article. The comments can be read below:
This isn't to suggest that ETFs don't deserve a place in a portfolio. One just needs to be aware that they are essentially on "auto" mode and will carry out their investment policy - regardless of negative consequences. They absolutely do fit a place in an investor's portfolio.
There are also ETFs that do have extra juiced up yields like CEFs. Although typically, we see the vast majority of ETFs only pay dividends (i.e. only the income received and passed through.) I say this as I am on the hunt for adding even more ETFs to my mixture of investments. I personally hold a number of dividend growth stocks too.
With all of this being said, ETFs ultimately can fit any objective you need them too. Whereas CEFs are typically more limited to income-focused investors, though there are always exceptions to anything. There are ETFs for growth, capital preservation, and income. There are even those that would fit in the speculation category.
Why CEFs and ETFs?
It has been said that diversification is the only “free lunch” in the markets, and this is something that we can fully take advantage of by investing in CEFs and ETFs, which are by nature diversified investment vehicles (i.e., typically owning a portfolio of stocks and/or bonds). You’re probably not going to hit a multi-bagger with a CEF or ETF like you can do with a small-cap stock, but at the same time, it’s unlikely for a position to halve overnight on some negative piece of news either. We've all seen this (but hopefully not been there) with those high-yielding, small-cap stocks that crash and burn when a distribution cut is announced.
In the long run, a diversified portfolio is likely to produce meaningfully higher risk-adjusted returns than a concentrated portfolio. Besides this academic rationale, there’s also a practical one: investing in CEFs and ETFs largely frees one from having to perform fundamental stock (or any other security type) analysis, as you’re either trusting the fund managers (in actively managed funds) or the market itself (in passively managed funds) to value the stocks for you. This can free up more time for other hobbies such as sports, or relaxing with family. While many do find fundamental stock analysis enjoyable, it’s not my cup of tea.
A final point that is rather unique to CEFs is that being by their nature closed-ended, they can trade at sizable premia or discounts to their net asset values based on investor sentiment, market demand, or sometimes seemingly at random. This opens up many interesting (and profitable!) opportunities for fund rotation or arbitrage that can add an extra layer of gains on top of an income-producing portfolio. At the CEF/ETF Income Laboratory, we have developed a CEF rotation methodology that allows for the double-compounding of capital appreciation and distributions in order to supercharge your income growth. We call this the "compounding income on steroids" strategy. See the link below for the specific steps needed to execute the strategy:
However, that's not to say that every CEF or ETF is perfect. There are pitfalls and landmines to be avoided. Some ETFs are based on shoddily constructed indexes that focus only on generating high income but with no thought towards distribution (or capital!) sustainability. With CEFs, some managers have interests that are misaligned with shareholders as they conduct frequent and highly dilutive rights offerings that destroy shareholder value while enriching themselves.
Moreover, even "good" CEFs can become overvalued due to sentiment or other reasons (e.g. yield-chasing), setting up for speculator losses (sometimes equivalent to years of distributions) for the unwitting investors who bought near the top. See:
- Why Closed-End Fund Valuation Matters: Two Recent Examples
- Why CEF Distribution Stability Is Overvalued
Part of what we do in our service is to help members avoid such traps. Such funds might look attractive on the surface, but aren't the most optimal way to achieve, and in some cases may even hinder, your investment objectives.
Double-Compounding Income In Action
Double-compounding our high income through reinvestment and attaining these "free shares" by taking advantage of market fluctuations led to significant income growth. This is when most high yield investments cut their distributions and dividends. Our Income Generator portfolio has an annualized income growth of 12%!
What good is an 8%+ portfolio yield if it continually erodes away or continually cuts so they aren't reliable or predictable? I'd say not a very good one, but that is just my opinion.
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CEF/ETF Income Laboratory: Profitable CEF and ETF Income and Arbitrage Ideas
Whether you're a novice or experienced closed-end fund ("CEF") and exchange-traded fund ("ETF") investor, the "Income Lab" is the right place for you. Our goal is to help you benefit from income and arbitrage strategies in CEFs and ETFs, all without having to be an expert, because we do the heavy lifting for you. If that sounds like something you'd be interested in, we hope you'll consider joining us here at CEF/ETF Income Laboratory.
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Stanford Chemist, Nick Ackerman, Alpha Male, Juan de la Hoz and Dividend Seeker
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