You’re probably well aware that exchange-traded funds (ETFs) are all the rage right now.

The low-cost, transparent investing vehicles have become immensely popular with retail and institutional investors alike, attracting an unprecedented $135 billion in cash inflows last quarter.

Remarkably, these funds now own a record-high 6% of the entire U.S. stock market.

You may even have an ETF or two in your own portfolio, maybe to track the S&P 500 or to gain exposure to emerging markets.

They can do a great job in that regard. But if your primary goal is current income, then you might want to reconsider.

Unless you’re happy with ordinary yields of 2% to 3%, take a closer look at the closed-end fund market.

While not as popular or trendy, closed-end funds (CEFs) were built specifically to maximize income. They regularly dish out generous monthly or quarterly payments, and when conditions are right, can provide total returns that crush their respective benchmarks.

Whereas ETFs passively mirror a fixed index, CEFs are actively skippered by veteran portfolio managers who can pick and choose the securities they feel have the highest potential. Armed with rigorous research and analysis, they also have the flexibility to avoid weak areas and overweight stronger ones.

But that doesn’t explain the outsized yields. After all, traditional mutual funds are also actively managed. But CEFs have an advantage, because they are able to utilize special strategies and tactics that are off-limits to ordinary funds.

The Highest Distribution Rates Around

One of the most tried-and-true income-boosting methods is the use of leverage. Simply put, this involves borrowing money at low rates and then reinvesting it at higher rates — with investors pocketing the difference.

For instance, there might be a $300 million portfolio earning 5% on average, which generates $15 million in annual dividends and interest. So the portfolio managers decide to raise money by issuing $100 million of low-yielding preferred shares. Those proceeds are immediately put to work. So now, there is $400 million to deploy, which bumps up the annual income stream from $15 million to $20 million.

That extra income (less borrowing costs) can be divvied up among shareholders in the form of higher monthly distributions. This practice can juice yields and optimize returns, but it can also magnify losses in a down market, something you should consider.

Other closed-end funds enhance their income stream by writing (selling) stock options on their underlying holdings. It sounds risky, but this technique can actually reduce downside risk and generate supplemental income to boost dividends. It can limit the upside in swiftly rising markets, but works well in sideways or declining markets.

By carefully utilizing these tactics, CEFs can regularly achieve payouts two to three times the market average… and sometimes more. I count 113 stock-based CEFs that currently offer yields in excess of 6%. And there are even more in the bond category.

That’s three times higher than the average dividend yield in the S&P 500 and far more than you’d get with a 10-year Treasury. But blindly selecting funds with the highest payouts is usually a recipe for disaster — just as with individual securities.

There are other factors to be considered. So how do you narrow hundreds of funds into a short list of high-quality candidates? Start by evaluating each of the five key areas below:

1. Cost

CEFs are almost universally more expensive than ETFs (most charge 1% to 2% annually). But don’t pay any more than you have to. Remember that management and administration fees can erode the value of your portfolio over time. With a wide selection of funds available, there is no reason to invest in one that is handicapped by excessive expenses.

2. Premium/Discount

Unlike ETFs, whose share prices tightly hug their portfolio net asset values (NAVs) at all times, CEF prices can diverge from the value of their underlying portfolio holdings. Sometimes they trade at a premium, but discounts are more common.

Take the BlackRock Resources and Commodities (NYSE: BCX). The fund has an NAV of $10.26 per share, but is currently trading at $8.94 per share. That’s a wide 13% discount, meaning the portfolio holdings can be bought for just 87 cents on the dollar.

It’s more important to view these discounts relative to the fund’s historical norms, rather than in absolute terms. In this case, the price is in line with BCX’s 5-year average discount of 13.2%. Look for situations where the price suddenly swings way outside of normal.

These pricing discrepancies are often short-lived. When it happens, you can often profit as the fund’s price converges back with NAV — even if the stocks and bonds in the portfolio remain flat.

3. Relative Performance

As they say, past performance does not guarantee future results. But it can give you a fairly good idea of how adept a fund manager has been at navigating a variety of economic conditions and market cycles relative to peers. Needless to say, I prefer those that have risen to the top of the class over the long haul.

Returning to BCX, the fund has delivered a return of 14.7% over the past year, versus 6.2% for the average natural resources fund. That gain ranks in the top 1% of the category, according to Morningstar.

Be careful, though, as fund managers often come and go with no fanfare. So pay attention to managerial tenure. Once you’ve found a solid long-term performer, make sure that the current manager is the same person who earned those returns, not a new unproven rookie.

4. Volatility

After scrutinizing the performance of elite funds across the spectrum, I’ve found a commonality. Nearly all earned their top rankings not by climbing the most in up markets, but by falling the least in down ones.

Avoid funds that got mauled during previous market downturns and concentrate on those that have given shareholders a smoother ride.

5. Portfolio Composition

Once you’ve found a stable, low-cost fund with a proven track record of success, it’s time to see what makes it tick — and why it has consistently outpaced the competition. Is it good old-fashioned stock picking, or does the manager have a knack for making concentrated sector bets?

Portfolio weightings and recent buy/sell transactions can yield clues about the manager’s expectations. For example, falling duration (a measure of interest-rate sensitivity) in a bond fund might indicate that he or she is bracing for higher interest rates. A shift into utilities and consumer staples could be defensive posturing signaling caution.

Does the fund use leverage (and if so, how much)? Does the manager plow most of the assets into 20 stocks, or diversify among 200? Is foreign currency exposure hedged or un-hedged?

These are things you want to know. Ideally, the fund’s objectives align closely with your own.

Finally, be sure to check the financial statements to gauge the level of dividend and interest income being generated by the portfolio net of fees, especially in relation to the fund’s distributions. If it’s dishing out $1.60 per share quarterly, but only earning $1.20, then we might have a problem.

Ideally, those numbers are flipped and the fund is out-earning its distribution, which leads to a rising level of undistributed net investment income (UNII) – a good indicator of a future dividend increase.

Fertile Ground For High-Income Portfolios

It’s true that closed-end funds have some of the highest distribution rates around. But don’t stretch beyond your comfort zone. Remember, higher yields generally indicate more risk. That could mean moving down a rung or two on the credit quality ladder, investing in securities with longer maturities, or utilizing heavy portfolio leverage.

These tactics can pay off. But they can also backfire under certain conditions, such as a faltering economy (and rising default rates).

One final word of caution. Some CEFs have so-called managed distribution policies, whereby a fixed payment is maintained each month regardless of the underlying income stream earned by the portfolio. If the stated payout is 8% and the dividends and interest only amount to 5%, then the shortfall must be covered by realized capital gains (which can’t be counted on in the future) and/or returns of capital.

That doesn’t mean these funds can’t generate healthy returns, only that their yield figures are artificially inflated.

I’ve recommended dozens of CEFs over the years, some of which racked up powerful triple-digit gains. Today, this remains one of my favorite fishing grounds for high yield, accounting for more than $12,000 in assets within my High-Yield Investing portfolio.

One of my favorites is the JH Financial Opportunities Fund (NYSE: BTO), which targets banks and brokerage firms. The fund offers a dividend yield of 4.3% and has generated returns in the top 1% of its category over the past 1-,3-,5-,10- and 15-year periods.

— Nathan Slaughter

Sponsored Link: To get the names of all of my top-performing CEFs, follow this link.

Source: Street Authority