Everything You Wanted to Know About CEFs and Weren't Afraid to Ask

Over the past seven weeks, we have explained the basics of closed-end fund, or CEF, investing. This included broad overviews of premiums/discounts, leverage, income evaluation, and expenses. Several readers had questions on the finer points that we had glossed over. This week, we answer some of the more specific questions posed to us in comments and emails.

How do leveraged CEFs stack up against ETFs bought on margin?
Two weeks ago, we addressed the trade-off between high expenses and the use of leverage in CEFs. We found that, although CEFs generally have higher fees than open-end funds because of leverage, the benefits of using leverage often make up for this cost, and then some. One user asked the natural follow-up question: Why not get the best of both worlds by buying low-cost exchange-traded funds on margin? After all, this seems like the logical alternative investment strategy.

This can be a difficult question to answer empirically. ETFs generally stray toward more-liquid securities because they are subject to frequent creations and redemptions. In comparison, CEFs typically take advantage of their closed capital structures and hold less-liquid securities. But even in the absence of a direct comparison, looking at the cost of leverage financing can shed some light on the issue. Depending on the size of one's portfolio, margin interest rates can range from 9.00% to 3.75% at major brokerage firms. CEF leverage is typically much lower, though it differs by category. For example, it is extremely rare for a municipal CEF to pay more than 2.00% for its leverage financing. In contrast, the higher end for fixed preferred share dividends paid by equity funds can be closer to 6.00%.

One way to make a quick comparison is to compare an ETF's "effective" expense ratio on margin with the total expense ratio of a CEF. The formula for the effective expense ratio is:

Stated ETF expense ratio + [margin rate*(desired leverage ratio -1)]

where the leverage ratio is equal to total assets/net assets. While it may make sense to use an ETF on margin in some situations, certain categories will almost always favor the CEF option. Let's look at an example.

Consider PowerShares Insured National Municipal Bond PZA (an ETF), which has an effective duration of 12.1 years and a weighted average credit quality of AA, and BlackRock Municipal Income Investment Quality BAF (a CEF with a leverage ratio of 1.51), which has a (leverage-adjusted) effective duration of 10.3 years and a weighted average credit quality of AA-.

PZA has the highest 30-day SEC yield of any municipal-bond ETF at 4.11%. Using the most charitable margin rate of 3.75%, an investor could effectively increase PZA's yield to 4.29% by leveraging his holding 1.51 times. In comparison, BAF is earning the least amount of net investment income of any comparable CEF, and it pays a distribution rate at share price of 4.95%.