Two and a half years ago, in the issue published the month before the beginning of one of the greatest snapback rallies in modern market history, we focused on closed-end funds that held Canadian income trusts and high-yielding corporations. Had you taken action based on the advice offered in the February 2009 Feature Article–perhaps even made your initial foray into Canada based on it–you’re likely a happy investor.

A few of the funds we profiled produced triple-digit gains, as did a lot of things coming off the bottom for North American markets established in early March 2009. By way of illustrating a point made in greater detail below, and conceding that its randomness begs as many questions as exciting points it raises, the February 2009 High Yield of the Month selections, both from the Aggressive Holdings, produced better total returns than the funds, several of which have since been absorbed as the income trust universe imploded.

From Feb. 9, 2009, the Monday following publication of the issue in question, Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) has generated a total return of 197.6 percent in US dollar terms. Vermilion Energy Inc (TSX: VET, OTC: VEMTF) is up 196.7 percent through Jul. 6.

The February 2009 Feature on funds included “Three to Buy.” Select 50 S-1 Income Fund, along with several other funds, was absorbed by Sentry Select Canadian Income Fund, now Sentry Canadian Income Fund, which is an open-end mutual fund. Since February 2009 the mutual fund has returned and impressive 113.5 percent in US dollar terms. Series S-1 Income Fund was acquired by Blue Ribbon Income Fund (TSX: RBN-U, OTC: BLUBF), which is now a Mutual Fund Alternative selection for the Canadian Edge Portfolio, in December 2009. Blue Ribbon, which has returned 178.5 percent in US dollar terms since Feb. 9, 2009, is detailed below.

ACTIVEnergy Income Fund (TSX: AEU-U, OTC: ATVYF), which is also detailed below, was recommended for those interested in a more aggressive bet on energy. It’s up 170.8 percent in US dollar terms, impressive but still bested by Vermilion for the period of comparison.

Alternatives suggested in February 2009 included DiversiTrust Income Fund, which was acquired by Dynamic Strategic Yield Fund, an open-end fund; Dynamic Strategic is up 105.4 percent for the comparable period. Brompton VIP Income Fund (TSX: VIP-U, OTC: BVPIF) is up 129.4 percent since Feb. 9, 2009.

Brompton has become significantly more aggressive since February 2009, when it represented a broad swath of the Canadian high-dividend-paying universe. Now Innergex Renewable is the only CE Holding in its top 10. Shoppers Drug Mart Corp (TSX: SC, OTC: SHDMF) is the largest holding, as of Mar. 31, 2011, at nearly 10 percent of assets.

Trading at a slight discount to NAV, Brompton VIP Income Fund is a buy up to USD12.

EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF) was sold from the CE Portfolio in December 2008. Since that time the fund has rebounded sharply, as management has gotten its leverage issues under control.

The discount to NAV has come down from 15.4 percent in February 2009 to 10.9 percent as of Jun. 6, reflecting a 154 percent total return during the same time frame.

Following a 1-for-3 split in March 2009, the fund now pays a CAD0.10 monthly dividend, good for a yield of 8.3 percent.

The portfolio is still very broad based, featuring relatively limited exposure to oil and gas production as well as Big Six bank coverage and contributions from pipelines, Canada’s healthy real estate sector, always in-demand waste hauling as well as the ongoing transition from print to Internet via Yellow Media Inc (TSX: YLO, OTC: YLWPF).

A sizeable run powered by a healthy Canadian stock market and a return to slightly more aggressive tactics make EnerVest Diversifed Income Trust a hold.

The share price for EnerVest Energy & Oil Sands Total Return Trust (TSX: EOS-U, OTC: EOSOF) has actually proven to more stable than the price of oil, which it should follow based on its high leverage to the commodity. The fund is a great way to gain exposure to top holding OSUM Oil Sands Corp, which is privately held. It accounts for 14.8 percent of EnerVest Energy & Oil Sands’ assets. Other top 10 holdings include Baytex Energy Corp (TSX: BTE, NYSE: BTE), Bonavista Energy Corp (TSX: BNP, OTC: BNPUF) and energy and transportation services provider Mullen Group Ltd (TSX: MTL, OTC: MLLGF).

EnerVest Energy & Oil Sands is a hold at current levels.

There are reasons to use closed-end and exchange-traded funds (ETF), including ease of exposure to investment themes of interest and as a way to hedge your overall portfolio against specific risks, such as inflation. But let’s not forget that the foundations of a solid portfolio are on solid, dividend-paying companies.

Funds: Why Not and Why

You could call it a founding principle of Canadian Edge that we income investors are better off building our own portfolios rather than handing over decision-making authority–and paying for doing so–to a manager whose interests may not always be aligned with ours.

The best way to build wealth over the long term, in other words, is to buy and hold dividend-paying stocks of solid operating businesses. You know what you own when you buy an individual company. You’re not left the bad and the ugly that too often come along with the good in broader-based portfolios.

When you buy a mutual, closed-end, open-end or exchange-traded fund, you’re hiring someone to manage your money. You will receive quarterly updates on fund holdings, but decisions about asset allocation are made by a manager or a team of managers. Parameters are thoroughly explained in fund documents, but such don’t stop active managers from jockeying to boost end-of-quarter performance figures, at real expense to investors.

There are other reasons to question the use of funds, but perhaps the most significant issue concerns the use of leverage. Many closed-end funds can borrow against their portfolios, which lets management try to capture the advantages of margin for capital gains. And it enables them to increase the fund’s yield above the distributions paid by its holdings and whatever capital gains are generated. That’s why many closed-end funds boast of yields far above the average high-yielding stock.

When the boom was on, leverage was a major advantage for closed-end funds–and a huge attraction for investors. But we learned at great pain the damage excessive leverage can cause to individuals, industries and economies from 2007 to 2009. Just as borrowing magnified gains and dividends on the way up, so it did the losses on the way down. Frozen credit markets meant dramatically rising costs of credit lines and other short-term debt instruments used by funds. That squeezed cash and imperiled previously juiced dividends.

And stock market declines inevitably trigger declines of similar magnitude for the funds that operate in them. Canada came down as hard as any developed market from late 2007 to March 2009, and so did the funds that trade on it s name. Resulting declines in portfolio values pushed some funds’ debt above the limits stated in their charters, which are typically set relative to NAV, or net asset value, which measures a fund’s assets minus its liabilities and is calculated on a per-share basis.

Some closed-end funds found themselves in violation of debt covenants, forcing them to sell holdings at depressed prices to pay off debt. That further depressed NAVs–and shareholder value.

Funds to Use

Closed-end funds hold portfolios of securities at the discretion of the manager. They do, however, differ in one key respect. Rather than mint shares when an investor wants to buy or cancel when there’s selling, closed-end funds trade a fixed number of shares on a major exchange. You never cash out or in. You buy and sell on the exchange just as you would a common stock or trust.

This conveys some advantages for the manager and, by extension, the investor. Primarily, managers never have to sell positions to meet redemptions in a bad market, and they never have to buy just because investors are putting money in. That gives them enormous discretion to stick with holdings that may be having a rough time in the market but still have strong fundamental value.

Another simple benefit is that certain closed-end funds can make for an efficient way to get exposure to the Canadian story, including some that have particularly significant exposure to the high-dividend-paying fare recommended in the Canadian Edge Portfolio. The Aggressive and Conservative holdings are well represented in many of the 12 closed-end and exchange-traded funds (ETF) profiled below, but you can also use these vehicles to get exposure to sectors and investments beyond the scope of How They Rate coverage.

ACTIVEnergy Income Fund (TSX: AEU-U, OTC: ATVYF) is one way to get exposure to most of the Canadian oil and gas producers covered in Canadian Edge. As of this writing ACTIVEnergy units are trading at CAD9.02, a 2.169 percent discount to NAV.

The fund’s top 10 holdings in terms of market of the fund’s position relative to overall assets–led by Vermilion Energy Inc (TSX: VET, OTC: VEMTF) at 8.3 percent–account for 65 percent of fund assets.

Bonavista, ARC Resources Ltd (TSX: ARX, OTC: AETUF), Canadian Oil Sands Ltd (TSX: COS, OTC: COSWF), Crescent Point Energy (TSX: CPG, OTC: CSCTF), Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF), NAL Energy Corp (TSX: NAE, OTC: NOIGF), Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF), Enerplus Corp (TSX: ERF, NYSE: ERF) and Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF) round out the top 10 holdings.

The fund is currently trading at a modest, 4.2 percent discount to NAV and yields 6.7 percent. Buy ACTIVEnergy for comprehensive exposure to Canadian oil and gas names up to USD10.

Blue Ribbon Income Fund’s (TSX: RBN-U, OTC: BLUBF) largest single holding is ARC Resources, at 5.3 percent. But it also holds Chemtrade Logistics, Extendicare REIT (TSX: EXE, OTC: EXETF), AltaGas Ltd (TSX: ALA, OTC: ATGFF) and TransForce Inc (TSX: TFI, OTC: TFIFF) in its top 10.

Paying about 6 percent and trading at a 4 percent discount to the value of its holdings, Blue Ribbon Income Fund is a broad-based fund alternative up to USD12.

FirstAsset REIT Income Fund (TSX: RIT-U), new to CE coverage, includes among its holdings a who’s who of Canadian real estate companies. The top holding is the solid H&R REIT (TSX: HR-U, OTC: HRREF), while Canadian REIT (TSX: REF-U, OTC: CRXIF), Calloway REIT (TSX: CWT-U, OTC: CWYUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF) also feature prominently.

The portfolio includes non-REIT real-estate focused Canadian corporations as well, including First Capital Realty Inc (TSX: FCR, OTC: FCRGF), which develops, owns and operates shopping centers anchored by grocery stores and pharmacies across Canada. Killam Properties (TSX: KMP, OTC: KMPPF) buys and redevelops apartment buildings and mobile home communities in Atlantic Canada, primarily Nova Scotia and New Brunswick. It’s a hold to start.

First Asset Utility Split Trust (TSX: UST-U) provides exposure to many names familiar to Canadian Edge readers, including Enbridge Inc (TSX: ENB, NYSE: ENB), its largest holding at 8.59 percent of assets as of May 31, as well as CE Portfolio Holdings Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPUF), Just Energy Group Inc (TSX: JE, OTC: JSTEF), Keyera Corp (TSX: KEY, OTC: KEYUF) and Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF), all of which are among Utility Split’s top 10 holdings. Utility Split’s top 10 holdings account for about 68 percent of overall assets.

As the name and composition of its holdings suggest, Utility Split focuses on utility issuers–high-yielding companies that generate, transmit and/or distribute electricity, water and/or natural gas. The trust can also invest in companies that supply the raw materials required for the generation of electricity.

The split security structure allows the trust to leverage capital raised from one class to boost portfolio returns. This is what makes it a little riskier than holding, say, the basket of energy service and infrastructure providers recommended in the CE Conservative Holdings. The trust currently pays CAD0.05 per unit per month, good for a yield of 4.5 percent, after slashing the divided from CAD0.09688 per unit in September 2008–as the financial/credit crisis began to heat up–to CAD0.0625 in October and then CAD0.025 by November 2008.

It trades at a steep discount to NAV, as do other closed-end funds that were forced to slash regular payouts excessively because of over-reliance on leverage. Exposure to another credit crunch, unlikely though it may be to approximate what happened three years ago–is the primary risk here. But if you must have efficient exposure, FirstAsset Utility Split Trust is one way to go.

A member of the same family of funds, First Asset Pipes & Power Income Fund (TSX: EWP-U, OTC: FAPPF), holds many of the same names Utility Split holds but without the split structure. Pipes & Power also slashed its monthly payout in the fall of 2008; it currently yields 4.6 percent.

The fund’s top holding, at 7.05 percent of assets, is TransCanada Corp (TSX: TRP, NYSE: TRP), which still awaits approval of its application to extend its Keystone Pipeline system to bring Canadian oil sands production to refineries on the Gulf Coast.

Enbridge, Innergex and Brookfield Renewable are the Nos. 2, 3, and 4 holdings and Keyera is No. 10. Pipes & Power provides a bit of differentiation from Utility Split, insofar as portfolio composition is concerned, by including Fortis Inc (TSX: FTS, OTC: FRTSF) in its top 10.

Trading at a 2.68 percent discount to NAV as of this writing, Pipes & Power has lagged its peers over the trailing year but is right in step over the longer, five-year term.

Again, if you simply must have someone else do the picking and the managing for you, First Asset Pipes & Power provides quick and easy exposure to high-quality names.

Triax Diversified High-Yield Trust (TSX: TRH-U) aims to generate a yield equal to the yield on the 10-year Canadian government bond plus 2 percent in addition to capital gains. The closed-end fund’s managers invest in an array of high-yielding securities, with an emphasis on Canadian corporates and other “specialty products.”

The top holding is Paramount Resources Ltd 8.25 Percent Note of 12/13/17, which accounts for 8.26 percent of net assets. Common shares of building supply outfit Vicwest Inc (TSX: VIC, OTC: VICUF) make up the second-largest position in the portfolio.

Among the top 10 holdings, which comprise about 55 percent of total holdings, are common equity shares of Just Energy Group Inc (TSX: JE, OTC: JSTEF, 5.11 percent of total assets). Triax Diversified also holds corporate bonds issued by North American Energy Partners, CCS Inc, Cott Beverages, Stone Energy Corp, Calfrac Holdings LP and Mirabela Nickel Ltd. Triax Diversified High-Yield Trust is a hold.

Precious Metals & Mining Trust (TSX: MMP-U, OTC: PMMTF), one of the December 2010 High Yield of the Month picks, has 17 percent of its assets devoted to Semafo Inc (TSX: SMF, OTC: SEMFF), a Canada-based gold miner with significant operations in West Africa.

As we noted in December, Precious Metals & Mining is “a high-quality but nonetheless heavily leveraged bet on the prices of metals and minerals, particularly gold.” Its No. 2 holding, at 12 percent of assets as at Mar. 31, 2011, is Allied Nevada Gold Corp (TSX: ANV, NYSE: ANV). Analysts who cover Semafo love the stock; 13 of the 15 on Bay Street who cover it rate Semafo a buy, while two say “hold.”

MMP certainly benefitted as Semafo rallied to near CAD14 per share in late 2010, but the measure of diversification it does provide allowed it to hold onto a lot of the value Semafo has since surrendered.

Top 10 holdings account for nearly 70 percent of assets. The simple truth with Precious Metals & Mining is that it’s a bet on the price of gold. Trading at a 13.8 percent premium to NAV, the fund–and its double-digit yield–is a buy up to USD12.

iShares MSCI Canada Index Fund (NYSE: EWC) is a straight-up bet on Canada, with four of the Big Six banks, the biggest railroad by market cap, the biggest oil sands producer, the biggest gold producers and the Great White North’s potash national champion among its top holdings. It’s currently trading well above its USD28 buy target.  

The ETF pays a miniscule semi-annual distribution, but management did boost it in June by 13.9 percent, a sign of return to dividend growth across Canada.

CurrencyShares Canadian Dollar Trust (NYSE: FXC) is redundant if you hold a significant amount of investments that pay dividends or generate substantial income in Canadian dollars. If you’re long the CE Portfolio, you’re long the loonie, which is what this ETF gets you.

Its price will track closely the relationship of the Canadian dollar to the US dollar. Although the long-term foundation of the Canadian economy is sound and there are continuing question about US fiscal, monetary and economic policy, there are few catalysts save those of the “black swan” variety to stimulate much more upside from here.

Parity looks set to hold for awhile. CurrencyShares Canadian Dollar Trust is a hold at these levels.