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An ETF Strategy That Delivers Rich Yields

NEW YORK ( TheStreet ) -- To reach yield-starved investors, exchange-traded fund companies have introduced portfolios that invest in closed-end funds -- funds that have a fixed number of shares and trade like a stock.

One of the highest yielding ETFs is YieldShares High Income (YYY), which yields 8.8% and has stakes in 30 closed-end funds. PowerShares CEF Income Composite (PCEF) yields 7.6%, while Market Vectors CEF Municipal Income (XMPT) delivers a tax-free yield of 6%.

Though the yields are tempting, keep in mind that closed-end funds can be volatile. During market downturns, closed-end funds have often lost more than traditional mutual funds.

Because they deliver rich yields, closed-end funds have long been favorites of income investors. Like mutual funds, closed-end funds hold portfolios of stocks or bonds. But closed-end funds can trade at discounts or premiums to the value of the assets in their portfolios.

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In contrast, mutual funds always trade for their net asset values. In recent years, closed-end funds have traded at average discounts of 4%. So investors have been able to purchase $1 of assets for 96 cents. The discounts boost the yields that investors can get from closed-ends.

Many closed-end funds increase their yields by using leverage. A typical fund might assemble a portfolio of $100 million in bonds. Then the portfolio manager would borrow $30 million against the assets and buy more bonds. That way the fund would collect income from $1.30 worth of assets for each $1 invested. While leverage increases gains in rallies, it can also magnify losses in downturns.

Leverage provides an important boost to closed-end municipal funds, says Jim Colby, senior municipal strategist of Market Vectors. Colby says that many of the municipal funds hold long-term BBB-rated bonds, which yield 5%. The closed-end funds can enhance the yield by a percentage point or more because of discounts and leverage.

For someone in the top tax bracket, the 6% tax-free yield of the Market Vectors ETF is comparable to a taxable bond that yields more than 9%. "The yields of closed-end municipals are extremely attractive compared to Treasuries or other taxable bonds," Colby says.

The PowerShares ETF holds a diversified basket of income funds, including many closed-ends that trade for discounts of more than 5%. The approach delivered healthy results in 2013, returning 4.8%, compared with a loss of 2% for the Barclays Capital U.S. Aggregate bond index.

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