ECAT - Consider Selling PCEF And Buying CEFS Instead

2023-12-12 12:08:49 ET

Summary

• Invesco CEF Income Composite ETF offers diversified exposure to income-producing closed-end funds with a strong 10.1% yield.
• Saba Closed-End Funds ETF has a stronger performance track record, due to savvy investment decisions and activist campaigns, making it my preferred choice over PCEF.
• An overview of PCEF, and a comparison to CEFS, follows.

I've covered the Invesco CEF Income Composite Portfolio ETF (PCEF) several times in the past . I've been bullish, due to the fund's diversified closed-end fund, or CEF, holdings and strong, growing dividends. I've also argued that the Saba Closed-End Funds ETF (CEFS) is slightly better, with similar diversification and dividends to PCEF, but a stronger performance track record. CEFS' continued outperformance has caused me to re-assess the merits of PCEF. At this point, CEFS seems like a much stronger investment, and so I would not be investing in PCEF.

PCEF - Basics

• Investment Manager: Invesco
• Underlying Index: S-Network Composite Closed-End Fund Index
• Expense Ratio: 1.99%
• Dividend Yield: 10.1%.

PCEF - Overview and Analysis

Holdings and Strategy

PCEF is an index ETF, tracking the S-Network Composite Closed-End Fund Index , an index of income-producing CEFs. Said index includes CEFs focusing on investment-grade bonds, high-yield bonds, and equity option income/call options, meeting a basic set of inclusion and exclusion criteria. Excessively expensive funds, with management fees higher than 1.25% and/or premiums higher than 20%, are not included in the index or the fund. Security weights are dependent on NAVs and discounts. As with most indexes, there are security caps meant to ensure diversification.

In most cases, the fund invests in its different asset classes in roughly equal measure. Right now, the fund is overweight equity option income funds, at least partly due to rising equity prices.

PCEF generally invests in slightly over 100 funds, currently 111. Each of these invests in hundreds, sometimes thousands, of securities. So, PCEF provides investors with indirect exposure to tens of thousands of securities, perhaps tens of thousands.

PCEF includes funds from most major CEF issuers, including Eaton Vance, Nuveen, PIMCO, and BlackRock. Right now, the fund seems to focus on BlackRock much more than in the past, with fewer PIMCO funds in turn. The largest holdings are as follows.

PCEF is an incredibly well-diversified fund, with exposure to all the major income-producing asset classes, hundreds of funds, and tens of thousands of underlying securities. In my opinion, PCEF could function as a core, even only , portfolio holding, as it includes basically all the funds and asset classes that income investors might need.

Dividend Analysis

PCEF's underlying holdings are all income-producing CEFs, which distribute significant amounts of income to the fund. PCEF in turn distributes said income to shareholders, resulting in a 10.1% dividend yield. It is an incredibly strong yield on an absolute basis, and much higher than that of most asset classes.

Dividends had been growing steadily all year, buoyed by higher interest rates and volatility (which means higher option prices/premiums). Dividends have grown 10.3% these past twelve months, very fast growth, especially considering the fund's strong starting yield.

On the other hand, dividends were cut this past September, reversing most of the growth above.

Right now, PCEF only generates around 8.9% in income, as per its SEC yield. Under these conditions, the dividend cuts above will likely persist into the future, and won't be reversed any time soon.

I am not entirely sure what caused PCEF's income to decline so much, and so rapidly. Equity volatility has decreased YTD, which has caused option prices to drop, reducing the income generated by most equity option CEFs. This almost certainly played a role, but doesn't explain why dividends were cut so suddenly.

Turnover seems like a likely culprit, especially considering the fact that income dropped so suddenly. I was unable to pinpoint a specific change that would have caused income/yield to drop so much, however.

In any case, PCEF's strong 10.1% dividend yield is a significant benefit for shareholders, recent cuts notwithstanding.

Performance Track-Record

PCEF is an index ETF with a portfolio of investment-grade bonds, high-yield bonds, and equity option income/call options, CEFs. As the fund is extremely diversified, and as it generally invests in these asset classes in equal measure, the fund should more or less perform as an amalgamation of said asset classes. Considering the fact that CEFs are generally leveraged, and could outperform due to active management, the fund might see slightly higher returns.

PCEF has slightly outperformed the average of its underlying classes since inception, in line with expectations. Performance has been particularly weak these past twelve months, with the fund underperforming during the same.

PCEF's performance track-record seems reasonably good, although nothing outstanding. Do bear in mind, that a diversified, broad-based index fund can't really ever significantly outperform the market, because it is the market.

PCEF is a reasonable investment opportunity, without significant risks or downsides. It does pale in comparison to CEFS. Let's have a look.

PCEF versus CEFS - Quick Comparison

PCEF and CEFS are broadly similar funds.

Both invest in a diversified portfolio of income-producing CEFs.

PCEF is generally more diversified, with investments in more funds and asset classes. Right now, CEFS seems slightly more diversified, with investments in a few more holdings than PCEF:

and exposure to alternative asset classes:

Both offer investors strong, double-digit yields. CEFS yields more including special distributions , less excluding these.

CEFS is a leveraged fund, using 26% leverage. Some of the fund's underlying holdings are also leveraged.

PCEF is not leveraged, although some / most of the fund's underlying holdings are.

PCEF is an index ETF, and so returns will generally track those of the broader market. Some outperformance is possible, as has been the case since inception.

CEFS is an actively-managed ETF, and so returns are partly dependent on specific management decisions, positioning, and execution. CEFS is aggressively actively-managed, with significant activist positions, short-term trades, short positions, and similar.

Considering the above, CEFS is riskier than PCEF, with greater potential for losses and underperformance. Said risks have mostly not materialized in the past, with CEFS having comparable drawdowns to PCEF. It is a bit more volatile, however.

On the flip side, CEFS's potential returns are much higher, too, contingent on the fund making appropriate investment decisions while limiting risk. This has been the case since inception, with CEFS significantly outperforming during the same. Outperformance is quite consistent, too.

CEFS's outperformance was due to savvy investment decisions made by the fund's managers, as well as some of Saba's activist campaigns. I've gone through these in more detail here , but two quick examples.

CEFS has, and had, a massive short treasury position, meant to reduce interest rate risk and profit from higher rates. Said position led to significant gains last year, during which interest rates skyrocketed.

CEFS's manager, Saba, sometimes buys significant stakes in discounted CEFs, and initiates activist campaigns to (attempt to) narrow the discounts. Said strategy was used on the BlackRock ESG Capital Allocation Term Trust ( ECAT ) to great effect earlier in the year.

CEFS generally makes savvy investments and trades, leading to significant gains and outperformance. Due to the magnitude and consistency of these, I much prefer CEFS to PCEF.

PCEF versus CEFS - Why I Changed My Mind

Although I've always preferred CEFS to PCEF , my preferences have become much more firm and significant these past few months for two reasons.

First and foremost, I was concerned about CEFS's massive short treasury position in the past, as I thought it could lead to significant losses if interest rates were to normalize. We've had a few periods of lower market rates/treasury gains in the recent past, and CEFS has continued to outperform.

CEFS's massive short treasury position remains something of a risk, but I feel much more comfortable about it now than I did in the past.

The second reason, is the fact that PCEF has had somewhat mediocre 1Y returns, especially in comparison to its underlying asset classes. A key advantage of PCEF is that, as an index fund, market underperformance is rare. If it isn't, due to turnover, discounts, or some other reason, then you might as well go for the better-performing actively-managed fund.

Considering the above, CEFS seems like a much stronger investment opportunity than PCEF.

Conclusion

PCEF offers investors diversified exposure to income-producing CEFs, and sports a strong 10.1% yield. Although there is nothing significantly wrong with the fund, the Saba Closed-End Funds ETF seems like a much stronger investment, so I would not invest in the Invesco CEF Income Composite ETF.

For further details see: