Income Strategy from ETF Pioneer
05/07/2014 10:00 am EST
YieldShares is an income-focused ETF that invests in a diversified package of closed-end funds; here, Christian Magoon explains the structure and strategy behind this unusual fund, which offers investors a current yield of 8.4%.
Steven Halpern: Joining us today is Christian Magoon of YieldShares (YYY). How are you doing today, Christian?
Christian Magoon: Doing well, Steven, and thanks for speaking with me.
Steven Halpern: Thank you for joining us. First, as background, you were president of Claymore Securities, which people may now know as Guggenheim Investments. You’ve also been called an “ETF pioneer” by the Financial Times and were named one of the “five people to watch in the ETF sector” by Institutional Investor. Could you briefly tell us why you believe investors should embrace ETFs as part of their long-term portfolio planning?
Christian Magoon: Thanks Steve. That’s a great question. One of the, I think, key areas that investors should consider when they look at ETFs are simply the initials of an ETF, and those initials—E, T, and F really, kind of, present the characteristics I think that make ETFs so appealing.
So, E stands for efficiency. ETFs are very efficient. Their cost is relatively lower than, for example, traditional mutual funds. They also are tax-advantaged from a structure standpoint. They have tax efficiency, which is important as it appears taxes are more likely to rise going forward than to become lower.
F is for flexibility. ETFs can trade throughout the day just like a stock, so they have a lot of liquidity behind them so that investors can respond to their current investment environment or individual portfolio situation.
Then T is for transparency. ETFs reveal their holdings every day, 365 days a year, 24 hours a day, 7 days a week. Being able to know what you own is very important.
Just to rephrase—E stands for efficiency; T stands for transparency; F stands for flexibility, and I think that’s a great way to think of the benefits of an ETF for an investor's portfolio.
Steven Halpern: Last year, you launched an ETF called YieldShares, which is focused on generating income through closed-end funds. So that our listeners better understand this strategy, before you talk about YieldShares, could you first explain the basics of closed-end funds and why you view that as an attractive area for income investors?
Christian Magoon: Sure. The first closed-end fund actually started in the US about 30 years before a mutual fund did. That was in the 1890s. Closed-end funds were really designed to create regular income distributions for investors.
The interesting part about closed-end funds is the word closed simply means that when they issue their original amount of shares, they generally leave those shares fixed or closed.
So that, when investors are buying and selling shares of a close-end fund, they are not actually interacting with the fund and the fund grows or shrinks in terms of size, instead, they are simply selling their shares or buying their shares on the exchange with other market participants.
Because there’s a fixed amount of shares, when there’s greater demand for the shares than there is supply, the shares can actually trade at a premium to the value of their shares. Likewise, when there’s more investors who want to sell shares than there is demand to buy them, the shares of a closed-end fund can actually trade at a discount to the net asset value.|pagebreak|
Essentially, what you get is pricing opportunities to buy, sometimes, a dollar’s worth of fund assets for less than a dollar, maybe 95 cents if there’s a 5% discount. Likewise, there’s times when, to buy a dollar’s worth of closed-end fund shares, you could be buying at a premium and buying them at $1.05.
We really believe that there’s opportunity in the closed-end fund space by focusing on funds that are being able to be purchased for less than the NAV of their securities, or to be bought at a discount.
What that does is allow you to capture a little bit more assets for your investment, which helps increase the amount of yield you can potentially get on your investment, and, secondly, gives you a chance to potentially have some capital appreciation should that fund stop trading at a discount, or move to a smaller discount, or maybe even move to a premium.
Steven Halpern: YieldShares, the ETF that you run that purchases closed-end funds, is based on an index called the ISE High Income Index. Could you explain the background of this index and its relationship to YieldShares?
Christian Magoon: Yes. Our fund is the YieldShares High Income ETF and our ticker is YYY—so, you’ve heard of the Q's for the Nasdaq 100, we’re YYY, where we try to be kind of a similar type of index spaced ETF, but for income investors. YYY's goal is to track an index and the index is the ISE High Income Index.
It’s an index, a rules-based index of 30 closed-end funds and those 30 closed-end funds are really selected based off a quantitative formula that looks at all 600 closed-end funds trading in the United States, and it selects the 30 closed-end funds that have the highest overall ranking in three categories.
One of the categories is distribution to investors, second is the discount to the net asset value of the fund, and then third is the liquidity of the fund, which looks at essentially market cap and trading volume.
Essentially, these 30 closed-end funds have characteristics of being higher distribution closed-end funds that, in general, are trading at discounts to net asset value, and have a fair amount of, what we would call, liquidity—the ability to not only transact on a daily basis, in terms of shares and trading volume, but also have a fairly large size in terms of the market capitalization of these funds.
For example, funds have to be $500 million or greater in assets for the ETF to consider them to be a part of the index.
Steven Halpern: As a result of that approach, the YieldShares YYY fund gives investors a chance to own a diversified package of closed-end funds, which helps reduce the risk of any one position. Could you explain how the fund becomes diversified across various asset classes and even across different strategies?
Christian Magoon: Sure. We start looking at the 600 closed-end funds and then, based off the three categories we just described, the 30 highest ranked closed-end funds are put into the portfolio. What we found is, currently, the mix is about 58% closed-end funds that invest in equity-oriented strategies.|pagebreak|
These are primarily stock-based closed-end funds that are actively, as a management style, writing covered calls in option strategies on US equities and international equities, so, 58% of the portfolio is invested in funds like that.
38% of the portfolio is invested in bond income funds and those types of bonds range everything from floating rate funds to high-yield funds to investment grade corporate bond funds, really span the gamut.
The remaining 4% of the portfolio is invested in multi-asset funds, which are a combination of stock and bond investments. If you think about it, the average closed-end fund probably has in excess of 200 actual individual holdings in its fund, so we own 30 funds that have around 200 holdings a piece.
All those funds are managed by some of the managers many people would recognize. The top managers of the closed-end funds we own are Blackrock, Eaton Vance, Nuveen, Allianz, PIMCO—very well-known household names and essentially, again, we’re simply try to create an index of these actively managed income funds that are diversified across asset class.
We’re probably one of the more diversified ETFs in the marketplace. In addition, we’re currently the highest yielding diversified ETF in the United States.
Steven Halpern: Speaking of the yield, YieldShares currently has a yield of 8.4%, which, as you mentioned, is very high. Do you have a target return that you’re looking for, and is this the type of return that you think investors could expect in future years?
Christian Magoon: Yeah, so, really, there’s two components of our fund's return. One is the component you just mentioned, and it’s the SEC 30-day yield of the fund, and that’s simply what we expect to pay over the course of a 12-month period. The fund pays out on a monthly basis.
In addition to the distributions from the fund, there’s the potential for capital appreciation, of course, also depreciation. Right now, based on the fact that the index has historically, kind of, been a blend of equity, stock, and bond closed-end funds, we’d expect that the returns would be similar to, kind of, a balanced portfolio, which would be somewhere historically around that 6% to 10% a year.
There’s potential to, obviously, do better or worse than that. One of the advantages the closed-end fund space has is that it is very distribution intensive, so, initially, no matter where the markets go, there seems to be a fairly large component of our return that should be part of the distribution return.
Whether or not the markets are up or down, basically, capital appreciation or depreciation will vary year-to-year, but I think a rule of thumb for a balanced portfolio in that 6% to 10% range on an annual basis is, probably, the range that the index and the portfolio will end up over the course of a business cycle of a five-year period.
Steven Halpern: Well, it’s a fascinating approach. We really appreciate you taking the time to join us. Thank you.
Christian Magoon: Thanks Steven and thank you for having me.