PCEF: Powdering The Pig

February 23, 2010

Friday saw PowerShares launch the first closed-end fund-of-funds ETF. You’d be hard-pressed to notice, and maybe that’s a good thing.

ETFs are all about transparency, right? Complete, X-raylike vision into your holdings. They’re touted as being (and are) better than mutual funds, in part because that transparency is effectively continuous and in real time. You not only know what you own, but the market tells you what that’s really worth with no delay.

Mutual funds, by comparison, muddy the water a bit: You get biannual or quarterly disclosures of your holdings, usually with a 30-day lag. On the upside, you get fair pricing: Every mutual fund can be redeemed at net asset value, every day, after the close of trading. Closed-end funds (CEF) muddy that not-all-that-clear tap water even more. Not only are the holdings obscure, but at any given time, the funds are not necessarily worth what you think they should be worth.

A CEF trades intraday on an exchange like an ETF, but there’s no arbitrage mechanism to keep the market price anywhere near in line with the actual underlying investments. As a result, closed-end funds trade all over the place, with premiums and discounts well into the double digits, based solely on market demand for the CEF shares themselves.

As Cinthia covered on Friday, the new PowerShares CEF Income Composite Portfolio (NYSEArca: PCEF) tries to make a kind of Reese’s Peanut Butter Cup out of a handful of closed-end funds by packaging them into an ETF wrapper. In fact, it tries to take advantage of the very flaw in CEFs I outlined above, by systematically underweighting those CEFs that are a rip-off (trading at a premium) and overweighting the ones nobody wants (trading at a discount). Sorry, did I just tip my hat there on my opinion of closed-end funds?

The only reason CEFs really exist is to take advantage of a single fact: Their portfolios are fixed. Once a CEF raises its initial capital, it can enter into long-term contracts, employ leverage, even issue secondary securities to raise additional (levered) capital to its heart’s content, without ever having to worry about a redemption. If investors don’t like what the manager is doing, they’ll sell the shares to a discount. If everyone’s a believer, they bid shares up to more than they are worth. It’s a great deal for fund managers: They can still charge 1 percent or more of the funds’ net asset value, with zero market accountability.

There’s still some accountability—CEFs are regulated mostly just like mutual funds. They’ve got boards with fiduciary responsibility, and for the most part, are just as good or bad citizens as the rest of the industry. The problem is that the structure isn’t inherently all that investor-friendly (I await the angry email from the Closed-End Fund Association.)

Just like mutual funds, you’re stuck with six-month disclosure frequency (with delays), and arcane reports at that. Just like ETFs, you’ll pay a commission and a brokerage fee to buy and sell. You’re also subject to the whims of the market in terms of premiums and discounts. They effectively take the worst of all possible worlds—zero transparency, high cost and unreliable pricing—just for a little bit of manager flexibility.

And now, PowerShares is wrapping them all up in a bow for us. At least, I think it’s a bow. As of this writing, while there is a prospectus available, it’s one of the thinnest I’ve ever seen. There’s no detailed discussion of what the underlying CEFs are actually being selected to do, no detailed discussion of the underlying index, where it comes from, or its past performance. There are no hypothetical return scenarios.

It’s about as boilerplate as it gets. There’s no fund fact sheet available. There’s no link to the index on the PowerShares Web site (I’ll give you one), and even when you get there, there’s no index data past 9/14/2009.

This is all actually odd, given that according to Bloomberg, the index (The S-Network Composite Closed End Fund Index) has kicked the pants of the S&P 500 in the last year and change.


CEFXTR Index vs SPX Index: 12/09 - 2/10


The underlying concept here is actually interesting to me—buying fixed-income assets through a structure that historically trades at a discount in order to capture higher yields. It’s a shame you have to wade through so much mud to get to the core.

And did I mention for all of this you'll pay upward of 1.8 percent in expenses, all in?



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