The PowerShares ETF stayed in the black by holding a broad mix that includes option-income stock funds as well as high-yield and investment-grade bond funds. PowerShares chose the different categories of holdings because they do not necessarily move in lockstep. During periods or rising rates, the investment-grade bonds may sink, but the stock and high-yield funds can rise.
With interest rates rising last year, many investment-grade funds suffered losses. But high-yield funds, which are rated below investment grade, stayed in the black. That occurred because the economy grew steadily. With corporate earnings improving, the risk of default declined, and investors bid up prices of shaky bonds.
The option-income stock funds also made money last year. The option-income funds start by assembling portfolios of stocks. Then they sell call options against the stocks. In a typical transaction, a stock holder sells a trader the right to buy the shares at a fixed price in the future.
Consider options on PepsiCo (PEP), a stock that recently traded for $79.71. A closed-end fund could charge a trader $6.75 for the right to buy PepsiCo a month from now for $72.50. By selling the option, the fund collects cash. If the stock stagnates or falls, the fund keeps the cash. But if the stock rises, the fund may have to deliver the stock to the option buyer.
Using the option strategy, the closed-end fund can deliver a rich yield. But in a rising market, the fund must give up highflying stocks and miss the upside. Last year the option selling produced modest gains. As a result, the PowerShares fund outperformed bonds but lagged stocks.
YieldShares High Income ETF holds a mix of closed-end funds that includes bond and option-income portfolios. The ETF starts by screening through 600 funds, eliminating small portfolios and those that rarely trade.
Then YieldShares uses a screening process that emphasizes funds with high yields and big discounts. The closed-end funds in the portfolio have an average discount of 5.9%.
YieldShares aims to focus on unloved funds that can rebound. "If you buy funds with larger-than-average discounts, you have a chance to obtain capital appreciation," says Christian Magoon, CEO of YieldShares.
In recent months, the YieldShares strategy has succeeded. With discounts on many funds narrowing, the fund has delivered steady returns.
At the time of publication, the author had no position in any of the securities mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.