Healthy Discounts Are the Best Insurance

05/05/2011 12:35 pm EST

Focus: ETFS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Buying cheap closed-end funds offers a margin of safety in volatile markets. A new ETF zeroes in on the biggest bargains in this often overlooked space, writes Richard Lehmann of the Forbes/ISA Closed End Fund & ETF Report.

In an uncertain market, the best bet might be buying stocks for less than their selling price. The only way to do that is to buy closed-end funds trading at a discount.

The PowerShares CEF Income Composite ETF (PCEF) is the first ETF investing exclusively in discounted closed-end funds.

The fund rebalances its portfolios quarterly to take advantage of funds trading at deeper discounts and sell funds that have lower discounts or even premiums. This tactic gives the ETF holder the benefit of always buying the cheapest income-oriented closed-end funds, at least on a quarterly basis.

The fund invests in three broad classes of closed-end funds: fixed income, high-yield, and covered call options. PCEF seeks out funds with a low expense ratio and enough liquidity and transparency to permit trading.

The fund's holdings currently trade at an aggregate discount of 5.56% versus the 30-day average discount of 5.77%. The fund currently yields about 7.9% and pays dividends monthly.

For a bigger price break, consider the Gabelli Global Health & Wellness (GRX) closed-end fund. It currently trades at a 17.1% discount to net asset value, versus its 52-week average discount of 16.8%.

The Gabelli fund uses leverage of 27.39% by issuing auction-rate preferreds recently paying 0.95%. The fund invests 83% of its assets in domestic stocks. It has an 11.2% concentration in Europe.

The fund recently increased the number of shares outstanding and offered the additional shares to existing shareholders at a discount. The fund does not pay a dividend or make regular distributions.

Several biotech exchange-traded funds, notably the SPDR S&P Biotech (XBI), along with a pharmaceutical ETF, have been among the market's top performers over the last month, and these gains might be an emerging trend in the health-care sector.

The industry is faced with uncertainty in the light of federal legislation, but remains one of life’s essential services. The resolution of uncertainty may boost the comfort levels and prices in this sector.

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