At Canadian Edge, we’re primarily stock pickers, and we assume that means just about all of you are, too. But that doesn’t mean there isn’t a place in your portfolio for pooled investment vehicles, such as mutual funds, closed-end funds and exchange-traded funds.

Although our Dividend Champions Portfolio offers a well-diversified array of dividend stocks for conservative income investors and yield chasers alike, we know that very few subscribers will actually go out and buy all of the nearly 30 names listed among our recommendations.

That’s why securities such as closed-end funds (CEFs) and exchange-traded funds (ETFs) can be invaluable: They offer instant diversification, which can help mitigate the risk of selecting individual stocks, whether it comes to targeting a specific sector or trying to keep pace with the broad market. Some even offer enticing yields.

Among our legacy holdings, the one closed-end fund that many subscribers seem to own is Canoe EIT Income Fund (TSX: EIT-U, OTC: ENDTF). It’s been a while since we’ve written about this fund, so we figured it was high time to provide an update on its performance.

With a market capitalization of around CAD1.5 billion, Canoe is one of Canada’s largest CEFs, and its stated aim to maximize monthly distributions by investing in a diversified portfolio of high-quality securities surely resonates with subscribers.

Indeed, at current prices, the fund’s distribution rate is around 10.6%, based upon a monthly distribution of CAD0.10, or CAD1.20 annualized.

Of course, it’s important to remember that you almost never get a high yield without high risk. In the case of Canoe, the fund can employ significant leverage to enhance its returns as well as its payout.

While the fund is permitted to borrow up to 20% of the value of the total assets of the fund, it last reported borrowings equivalent to around 6.9% of net assets at the end of June. Such leverage can boost returns during bullish periods, while magnifying losses during bearish periods.

There’s another factor contributing to the fund’s high distribution rate. Unlike mutual funds, CEFs have a fixed number of shares, though that can change periodically if management institutes a share repurchase or makes a secondary issuance to raise new capital.

As a result, the share prices of many CEFs deviate widely from the net asset value (NAV) of their portfolios. Canoe, for instance, currently trades at a nearly 12% discount to its NAV.

That might make the fund seem like a screaming buy, but many CEFs trade at a persistent discount to their NAV. Consequently, it’s worth comparing the current discount to the premium or discount that prevailed over a longer-term period to gauge whether the CEF is truly offering a compelling value.

It might seem counterintuitive, but on that score Canoe is actually somewhat overvalued at present. Over the past three years, for example, its discount has averaged nearly 14%.

Canoe has managed to outperform the S&P/TSX Composite Index by a wide margin over the trailing 15-year period, at nearly 9% annually versus a 4.8% annual return for the market. But it’s moderately lagged this benchmark over more recent periods, such as the trailing three- and five-year periods.

However, the current portfolio manager, Robert Taylor, has only been at the helm since August 2013. So he doesn’t get credit for Canoe’s enviable long-term record, but he also doesn’t get full blame for its performance over the past five years.

Taylor takes a value-oriented approach to stock selection, looking for quality stocks with strong growth characteristics that have temporarily fallen out of favor with the market.

While most of Canoe’s portfolio is invested in Canadian stocks, a sizable portion of the fund’s assets, at around 39.0%, is invested in U.S. equities.

Interestingly, there are few Canadian stocks among Canoe’s top-10 holdings. Right now, for instance, the fund’s largest holding, at 4.9% of assets, is Wells Fargo & Co.

The biggest Canadian holding is the global media company Thomson Reuters Corp., at 4.0% of assets, followed by our Legacy Aggressive Holding Peyto Exploration & Development Corp. (TSX: PEY, OTC: PEYUF), at 2.9% of assets.

During Taylor’s tenure, the fund has declined 3.4% on an NAV basis, while the Canadian market has climbed 7.6% on a price basis in Canadian dollar terms.

While that is a market-lagging performance, it’s not a huge gulf in return by any means. And two-plus years isn’t quite long enough to make a judgment about Taylor’s ability to beat the market.

From a U.S. investor standpoint, it also should be noted that Canada’s falling exchange rate has been a drag on returns, making a somewhat underwhelming performance seem even worse.

Even so, many investors are likely more fixated on the fund’s high yield than its performance. But here again, additional scrutiny is in order.

Beware the Dreaded Return of Capital

A CEF’s monthly distribution can be derived from several sources including short- and long-term capital gains, dividend or interest income, and return of capital. Investors should be especially wary of the latter, particularly for CEFs that have managed distribution policies, which means that their monthly payouts don’t fluctuate based on investment income.

These days, most CEFs have managed distribution policies. The companies that offer them know that these high-yielding securities primarily appeal to retail investors who’d like to be able to depend on a level payout month after month.

In the real world, however, a fund isn’t always going to fully cover its monthly distribution. So in the short term, sometimes even the best CEFs have to return capital to shareholders in order to make their monthly nut.

But if a fund makes a habit out of regularly returning capital to shareholders, then over time it can actually destroy shareholder value. In a basic sense, a return of capital means that the fund is giving you your own money back net of management fees, such as Canoe’s 1.5% annual expense ratio.

Naturally, there are exceptions to this. The one that most likely applies to a fund like Canoe is when management returns capital in order to maintain positions in which it has significant unrealized capital gains. In this situation, shareholders should want management to let their winners run rather than paring them simply to make a short-term payout.

So how do you know whether management is engaging in destructive returns of capital or simply looking out for the best interest of shareholders? According to Morningstar, one rule of thumb is to compare the fund’s net asset value prior to the distribution to the net asset value at the end of the period. If the latter is at least equal to the former, then the return of capital is considered constructive.

A review of Canoe’s financials shows that the fund has returned at least some capital to shareholders in each of the past five years. In 2011 and 2012, it does appear that return of capital may have been destructive, with each annualized return of capital equivalent to about 2.0% and 5.4%, respectively, of the fund’s net asset value at the beginning of each year.

Should you stick around anyway? Well, if you can overlook some of Canoe’s shortcomings, it’s one of the few Canada-focused funds that offers a high yield and is readily available to U.S. investors.

True, that high yield has been at least partly illusory in some years. But we’re not quite ready to kick the fund to the curb just yet. For now, Canoe is a Hold.