ETFs have seen their popularity explode in recent years.
CEFs remain highly popular and spawned an entire type of investing strategy.
Investors often disagree on their strategy. This is because every investors goals are different. As investors, we like to lump people into groups or communities who are striving for similar, but not identical goals.
These groups often disparage each other and believe their methodology is superior. According to Sociology, this is a classic example of othering. What does that mean? Remember back to high school. Typically there is the in crowd, and the freaks or others. These others were marginalized and often ignored or worse – bullied. Seeking Alpha like a high school has crowds of individuals who typically adhere to one investing style and when an article or author publishes a different idea – it gets attacked. These groups feel threatened when others arrive. It threatens their preconceived ideas.
Othering is seen on national scale as well, but investors being from all nations create groups of their own. One classic argument is ETFs, Exchange Traded Funds, versus CEFs, Closed End Funds. Both of these options contain hundreds of examples that encapsulate various investing methodologies. They can be actively or passively managed and investing in a single sector or all of them. ETFs vs. CEFs creates new divides among investors who align with similar investing theories.
At High Dividend Opportunities, we recommend to invest in a large selection of high-yield ETFs and CEFs. We are very selective in the options we include in our core portfolio. CEFs strongly outweigh ETFs – let us take a look at why.
An ETF is an exchanged traded open end fund – meaning it can actively create or redeem shares as needed. This means there is no limit to how large a fund can become. Theoldest survivingETF currently is SPDR S&P 500 Trust ETF (SPY) and tracks the S&P 500 index. These options rarely stray far from their NAV and prices are reset to them almost nightly.
One of the biggest draws for ETFs is their instant diversification for passive or conservative investors. ETFs generally hold a basket of a large number of stocks. This is a benefit and a drawback.
This means you get the best and the worst of the underlying stocks. Generally, this basket is determined by the index it tracks. SPY quietly tracks its index and provides exposure to the entire S&P 500, even if an investor does not have the cash available to buy a single share of each company within it.
Bottom Line:Benefit of access to a large number of holdings. Drawback of limited control to avoid bad companies.
ETFs will have one of two management styles. The most common is passive. This means that the ETF tracks an index as closely as possible. As new shares are generated based on cash flows into the ETF, the ETF buys the weighted balance of shares of its indexes securities. Actively managed ETFs like InfraCap MLP ETF (AMZA) have portfolio managers who invest according to the limits of an index but are competing against it instead of blindly following it. AMZA is an example where this style of management can fail to beat its index and stands as an example where this management style is heavily dependent on the portfolio managers for success.
Bottom Line:Typically passively managed ETFs are more common and more popular for hands-off investors.
This is a major draw for ETF investors. Buying and selling ETF shares is extremely easy. Youre not dependent on other investors alone but the fund also to redeem or create shares near the NAV, net asset value, price. This means it is very easy to buy into an ETF and sell out of it. This provides investors an easy route to get diversification in areas where volume can be low and diversification can be hard. Plus, selling those same holding in a pinch can be hard.
The flip side of this means that often ETFs can have irrational sell-offs when the NAV drops. This can create a feedback cycle where the selling of shares forces redemptions and can cause the funds NAV to drop further. This is amplified when the underlying holdings are highly illiquid. ETF investors often buy when a funds holdings are performing well – creating a buy high, sell low issue for the fund. New buyers force it to buy shares at higher prices and sell them at lows.
Invesco Senior Loan ETF (BKLN) is an example of this phenomenon. BKLN buys and holds senior secured bank loans – these are more illiquid than normal securities. In the third quarter of 2018, BKLN saw a steady uptick in selling, to redeem the shares the fund had to quickly sell loans that normally take time to sell. This means selling at cheap prices – further hurting the NAV and flooding a market known to be illiquid with extremely cheap loans.
This added liquidity of an ETF caused this funds NAV and thus share price to drop rapidly. Ironically, this was not because the loans were facing added pressures – defaults remain at an all-time low.
Bottom Line:Added liquidity can help investors move readily in and out of ETFs, but this sword is double-edged and can readily hurt investors who dont need the added liquidity.
A CEF is a closed end fund, this means that the fund has a set number of shares available on the market. The fund can issue more shares over time but unlike ETFs, CEFs do not issue and redeem them in the same fashion. This set number of shares means CEFs have a NAV value and a market price. Savvy investors have created a breed of investors who trade exclusively based on CEF metrics to capture market inefficiencies due to mispricing of a CEFs NAV vs. market price.
Like an ETF, CEFs offer cheap diversification as well. CEFs typically invest in holdings related to a sector or index.XAI Octagon Floating Rate & Alternative Income Term Trust(XFLT) currently yields 8.84% and invests in the senior loan and CLO sector, for example. Meanwhile,Liberty All-Star Equity Fund(USA) invests across a broad range of sectors to achieve its goal.
CEFs more so than ETFs have a specific goal or style of investing in mind. All CEFs have a manager who oversees the portfolio choices of the fund as well as its distributions.
Bottom Line:CEFs provide diversification. Their holdings are frequently updated and sometimes can be harder to track than ETFs. Portfolio managers aim to avoid the bad investments that ETFs passively invest your dollars in.
CEFs are unique compared to ETFs that they can trade at a discount or premium to NAV. These metrics are used by some investors to buy into funds that are discounted – thus every dollar invested by you buys more than that dollars worth of what the fund is invested in. Conversely, popular funds will often trade at a premium to NAV where every dollar you invest is backing less than that dollars worth of investments.
Why would an investment trade at a constant premium? Some funds are invested in assets that are illiquid and hard to value or are trading at a discount themselves. ConsiderOxford Lane Capital (OXLC) orEagle Point Credit(ECC) yielding 16.22% and 14.21%, respectively. They have been trading at a premium for an extended time; meanwhile,OFS Credit(OCCI) has been trading at a discount.
OCCI recently IPO-ed, and new funds typically trade at a discount to NAV. Meanwhile, OCCI hasnt updated its NAV since 12/31/18 – meaning it very well could be at a premium and we dont know right now.
Bottom Line:Investing in a discount to NAV can leverage your dollars; however, limiting your investments to only those trading at a discount would cause you to miss many opportunities.
CEFs offer similar liquidity to common equity and much less liquidity than ETFs. This is because they trade in a similar manner to normal equity trades. This is a benefit for investors looking to invest in less frequently traded securities like bonds and loans, for example. OXLC and ECC might face strong market price declines but their NAV will be unaffected – this is because the NAV is not directly impacted by the markets selling off the fund itself.
While providing an easier out from an asset type than it may normally provide, the large lumbering ETFs in that sector can vastly affect NAV values – as seen in December. The irrational selling of BKLN caused OXLC and ECC to see irrational NAV declines and thus market share price drops. Their underlying assets continued to generate strong returns.
Bottom Line:CEFs provide higher liquidity for many highly illiquid asset classes while conversely offering less liquidity than ETFs provide.
So how does High Dividend Opportunities utilize ETFs and CEFs? Recently weve gained attention for investing in CLO funds like OXLC and ECC. But many of our readers know we have invested also inVanEck Vectors BDC Income ETF(BIZD) which yields 9.65% andiShares Mortgage Real Estate Capped ETF(REM) which yields 9.08%. We use these ETFs to allow conservative investors easy access to diversification across these sectors where many landmines exist.
We use ETFs as a means for conservative investors to get exposure to a sector that is 1) potentially high risk and 2) the sector as a whole should see tailwinds for improvement. We also invest in specific high-quality choices in these sectors as well. The ETFs exist in our conservative portfolio while the individual choices in our Core portfolio. Why? Investing in a single choice can be considered a higher risk choice but also higher reward. This single or couple of choice investments can lead to a higher return.
Ares Capital(ARCC), which yields 9.05%, is a key example of this. A choice high-quality BDC to invest in versus an ETF that invests also in lower quality ones.
We use many CEFs with proven track records in our portfolios. TheseCEFsweve touched on recently in the REIT space. These funds allow us to convert capital gains the fund sees into income streams.Adams Diversified Equity Fund, Inc.(ADX) provides large sums of year-end income from its underlying capital gains from securities we wouldnt otherwise have exposure to. It also provides the income we desire for our portfolio and lifestyles.
We use CEFs to 1) leverage the skills of the portfolio manager 2) gain income from sectors that typically dont provide them and 3) gain access to asset types we wouldnt have access to anyways.
ETFs and CEFs can cause strife among investors over the superiority of either as well as how to best use them. Here at High Dividend Opportunities we actively use both investment vehicles to achieve our goal of a portfolio yielding between 9-10%. Our conservative investors are able to access similar markets as our less-conservative investors via ETFs to have the added downside protection of diversification while also limiting their upside. CEFs give us access to new asset types and ways to produce income from non-income generating securities.
We are the largest community of income investors and retirees with over 2700 members. Our aim is to generate high immediate income. We recently launched ourall-Preferred Stock & Bond portfoliofor safe high-yields ahead of a weaker economy and market volatility.
Join us today and get instant access to ourmodelportfoliotargeting 9-10% yield,ourpreferred stock portfolio, ourbond portfolio, and income tracking tools. You also get access to our report entitledOur Favorite Picks for 2019
Disclosure:I am/we are long OXLC, ECC, XFLT, ARCC, BIZD, REM, ADX.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.
Additional disclosure:High Dividend Opportunities authors Rida Morwa, Treading Softly and Beyond Saving, who have worked on this report, will be happy to reply to your comments/questions.