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Newsletter Adam Sommers Income Investing

Closed-End Fund Arbitrage

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During a recent conversation about how to invest her portfolio, while looking at our model portfolio offerings, a client remarked about our Closed-End Fund (CEF) Arbitrage model: “Well this one appears to have the best potential for higher returns, without taking on any more risk than the ‘Conservative’ model. Why wouldn’t everyone choose CEF-Arb?”

I agree that when comparing our model portfolios, the CEF-Arb model has the best risk/reward profile of any of them. The potential downside is similar to our Conservative Models, yet the upside is similar to our Aggressive models – and it boasts the highest dividend yield of any of them by far. The best of all worlds, right? That’s by design. 

While creating this strategy, I looked for ways to lessen stress for our clients (by trying to avoid big drops in value), provide a nice income yield, still have potential for growth from a professionally-managed, diversified portfolio, all while maintaining intra-day liquidity so our clients have easy access to their funds (unlike a hedge fund’s lack of liquidity).

Fine tuning the design of our model portfolio has taken more than a year, thanks to a few of our intrepid clients acting as guinea pigs while we tested our ideas. Currently, our CEF-Arb model has:

  • A Current Income Yield of 7.1%
  • A Total Return target of +9.7%
  • Average Fund Expenses of 0.85%

Potential 6-month downside: -7% — with 95% certainty. (That’s even less than the statistical 8% potential drop of our Conservative SIP, and less than half the potential loss of the S&P 500 Index.)

We obtain these benefits by investing in heavily discounted, high-yielding closed-end funds, while simultaneously hedging nearly 75% of our exposure via index ETFs that are inversely correlated with the CEF portfolio holdings. This method of hedging leaves us with 25% of a traditional portfolio’s exposure to market volatility. The current CEF-Arb model includes high yield bonds, small-cap and large-cap U.S. and international stocks. 

If you’ve dialed in your Risk Number (You—we—should know this number…) to between 35 and 55, SFM’s CEF-Arbitrage may be a fit for you — especially if you’re aiming to generate sustainable income.