Exchange-traded funds are one of the easiest ways for income investors to access a plethora of high-yield investment options. These low-cost, transparent, and flexible vehicles are perfect for pinpointing a precise dividend-generating asset class and giving you instant exposure. There are select ETFs that hold high-yield bonds, preferred stocks, mortgage REITs, master limited partnerships, and even those with a blend of all four asset classes. In addition, you can select between numerous index strategies, average duration, and other factors to determine the best mix for your portfolio.
Some of the most well-known high-income ETFs and their current yields include:
SPDR Barclays High-Yield Bond ETF
iShares US Preferred Stock ETF
iShares Mortgage Real Estate Capped ETF
Alerian MLP ETF
One of the benefits of using an exchange-traded fund for high yield is that you know exactly what you own and how it is constructed. The fund providers do an excellent job of posting the ETFs' holdings, credit ratings, average duration, yield, sector breakdown, and more. All of this information is available in almost real time so that you have an accurate picture of the qualities that will affect the ETFs' price and yield.
There is another type of dividend machine called a closed-end fund (CEF) that sophisticated income investors have been using for some time. CEFs are similar to ETFs in that they are a basket of underlying securities that's traded throughout the day. However, most of the similarities end there. CEFs are created by an initial public offering that raises money to seed the fund and is then actively managed according to the constraints of the prospectus. Unlike ETFs, which create and redeem shares throughout the day, CEFs have a fixed number of shares and can therefore trade at a premium or discount to the fund’s net asset value.
The benefit of a CEF is that the fund manager is able to actively select and hold investments according to their research and analysis expertise. Because the number of shares is fixed, they do not have to sell distressed holdings at inopportune times to satisfy redemptions. In addition, CEFs are able to use leverage and unconventional strategies, such as options, to enhance their returns over time. They are also able to diversify their portfolios in ways that many passive index-based ETFs are unable to replicate.
Two closed-end funds that I think offer excellent income and capital appreciation potential are the Guggenheim Strategic Opportunities Fund
(NYSE:GOF) and the PIMCO Dynamic Income Fund
(NYSE:PDI). GOF is a combination of high-yield bonds, preferred stocks, bank loans, and other income securities that coalesce to produce a current yield of 9.90%. PDI, on the other hand, offers access to Pimco’s best income-generating ideas from multiple global fixed-income sectors. The fund has a current yield of 7.67%, and the majority of its portfolio allocation is to mortgage, international, and high yield bonds. GOF is currently trading at a 9.42% premium to its NAV, while PDI is sitting at a 6.48% discount. Both of these funds employ leverage in their quest to enhance yield and magnify returns over time.
While closed-end funds offer excellent income opportunities, they are also susceptible to certain risks as well. The use of leverage as well as high buying or selling volume can enhance volatility and lead to greater price fluctuation than a more traditional ETF or open-ended mutual fund. In addition, CEFs often have higher fees (in the range of 1%-3%) for the ongoing active management and operation of the fund. Each of these factors should be considered before purchasing a closed-end fund for your portfolio.
There are undoubtedly pros and cons for the use of both ETFs and CEFs depending on your risk tolerance, time horizon, and objectives. Both tools can be valuable resources in your dividend portfolio. In my experience, CEFs are often times the most attractive during periods of distress when premiums narrow or discounts widen. Value-seeking income investors can swoop in and scoop up bargains when a disconnect presents itself.
A great free resource to check up on CEFs is at Morningstar where they present you with detailed information on price, NAV, long-term averages, and more. The key is to be vigilant by monitoring opportunities and pouncing on them when the timing is right.
Read more from David Fabian, Managing Partner at FMD Capital Management:
Four Trends to Watch in the Fourth Quarter
How to Strengthen Your Portfolio Core
5 Mistakes to Avoid With Your ETF Portfolio
Position in GOF, PDI, and PFF.