“So, real simple, it's kind of like a decathlon of three events,” said YieldShares founder and CEO Christian Magoon, discussing the strategy the company uses to evaluate closed-end funds for its signature YieldShares High Income ETF Exchange Traded Concepts Trust YYY.
Previously, in part one, Magoon laid out strategies for investing for income through ETFs.
Benzinga: What is the YieldShares High Income ETF?
Christian Magoon: It's a unique product in the sense that it's an exchange-traded fund that goes out and buys closed-end funds (publicly traded investment companies with a fixed number of shares).
BZ: What are some characteristics of closed-end funds?
CM: First, there are about 600 closed-end funds listed in the United States, owned mostly by older people who tend to be retired. They're really income vehicles.
Almost all closed-end funds pay out either monthly or quarterly. About 60 percent or so are debt closed-end funds. The remaining 40 percent are equity closed-end funds, dividend funds or option income funds.
BZ: Why are there so few closed-end funds compared to mutual funds and ETFs?
CM: The reason closed-end funds really aren't as popular as ETFs or mutual funds are, is that they have a bit of an Achilles’ heel, found in the word "closed."
Unlike an ETF or a mutual fund, (a closed-end fund) can't shrink its shares outstanding or grow its shares outstanding to meet market supply or demand. Instead, the same number of shares is always outstanding.
BZ: How does this (set number of shares) affect market sales?
CM: When the market wants to sell that fund, it trades on exchange like an ETF. The shareholder is essentially trying to get somebody in the marketplace to buy it.
If there are more people selling than buying, the market price starts to drop below the actual NAV (net asset value) of the fund.
When there are more buyers than sellers, the market price rises above the NAV of the fund. That all sounds good, but there’s a problem.
BZ: What’s that?
CM: Over the last 15 years, the average closed-end fund has traded at about a 4.5 percent discount from net asset value.
Imagine you bought the closed-end fund on the IPO, with a 4 to 4.5 percent sales charge.
So, you paid $1.04 for this asset that right away begins trading at a NAV of $1.00. Once it starts trading in the market for a while, investors will often be able to buy that asset for roughly $0.945.
That's a bad investment if you're buying it for $1.04 and it's worth $0.94 three months later.
BZ: What does all this have to do with YieldShares High Income ETF?
CM: We tried to take advantage of the fact that closed-end funds trade at a discount, because, like every good American, we think buying things on sale actually works pretty well.
In addition, unlike any other area where opinion determines whether a stock is overvalued or undervalued, with a closed-end fund that is not the case. With a closed-end fund, the NAV is the NAV.
We said, "Hey what if we created an index that went out and looked at the entire closed-end fund universe, and had some minimum market cap and liquidity requirements. Then we could screen out some of the very small, less liquid closed-end funds and concentrate on more of the broad-based, appealing funds that have a fair amount of investor interest that trade at a fair amount."
BZ: So, how are the funds ranked?
CM: We rank them on the level of income they're paying, the amount of their discount to NAV and their liquidity.
We have an index called the ISE High Income Index that looks at all 600 closed-end funds, screens out any fund that's not at least half a billion dollars market cap and that does trade at least a million dollars a day.
BZ: Then what?
CM: That takes the 600 closed-end fund universe roughly down to about 200 funds that meet those liquidity criteria.
Then all 200 funds are ranked using three separate weighted criteria.
Fifty (50) percent of the weight comes from income paid from the closed-end fund. Twenty-five (25) percent comes from the liquidity score and the other 25 percent comes in terms of discount to NAV.
BZ: So, it's a three-part strategy?
CM: So, real simple, it's kind of like a decathlon of three events. Eventually (each fund) takes either first place, all the way down to 200th place.
The 30 funds that get the highest overall scores in those three events become the index.
BZ: What about diversification?
CM: We do something called a modified linear rating in which no fund can be greater than 4.25 percent.
Long story short, you get a portfolio or an index of 30 closed-end funds that come from a variety of different asset classes, representing a variety of different strategies and including a variety of different managers and management styles.
BZ: And the net result for investors?
CM: That mix creates diversified stock and bond portfolios of closed-end funds. I think our discount to NAV of the average closed-end fund was trading about an 8 percent discount.
So, you're able to go out and for $0.92, buy $1 worth of assets that's generating income of about 8 percent.
At the time of this writing, Jim Probasco had no position in any mentioned securities.
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