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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.

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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