facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause

We're Finding Bargains in Closed-End Funds

%POST_TITLE% Thumbnail

It’s been over a year since we launched our long/short (L/S) Closed-End Fund (CEF) Arbitrage strategy. In the seven months prior to that, we experimented with L/S pairings, to test our strategy. 

We had a client commit $10,000 to try out our Long/Short CEF-Arb strategy on March 28, 2016. One year later, on March 31st, their account was valued at $11,315—up over 13%, after fees. The biggest swoon the account experienced was a drop of 2.9% in October. That compares to the S&P 500, which saw a 17% return in the same 12-month timeframe, but experienced a drop of 6% in June. This is what the investment world would call a good upside/downside ratio. We captured 76% of the market’s move up, but only 48% of the move down. A golden goose? Almost! 

The biggest issue we’ve had with the long/short design is that it is hedged, or offset, by shorting market-index-ETFs. This results in underperformance when the market performs well. While this may not be important to our clients looking for stability, others want to leverage our CEF analysis to achieve more robust (i.e. aggressive) returns. 

This spring, I set out to create a portfolio of mis-priced, bargain CEFs that we don’t hedge. In order to reduce volatility, and keep the downside lesser than that of the S&P 500, I decided to use a 60/40 Stock/Bond allocation, akin to a typical “Balanced Fund” in the mutual fund world. 

We place U.S. stocks, real estate and international stocks in the “Stock” bucket, and high quality, high yield and international bonds in the “Bond” bucket. Our volatility projections are higher than a typical balanced mutual fund, but our goal is 2% annual out-performance. 

Our two CEF strategies share many of the same funds, but are not identical handfuls. Additionally, we weight the portfolio holdings differently, based on each strategy’s objective. 

For the hedged, or long/short version, we calculate the amount of hedge based on volatility. The more volatile the CEF, the more we hedge. The more we hedge, the less return we expect.  

We then weight both strategies by a calculation equivalent to “Expected Return/Volatility”. We  aim to achieve the highest return with the least amount of risk (volatility). 

All this to say we now have two Closed-End Fund Arbitrage models available to our clients. One aims for the steady, positive returns with very little volatility in principal. The other is a balanced portfolio of stock and bond CEFs that aims to out-perform typical balanced mutual funds by using our specially developed process of identifying mis-priced CEFs. Give us call to discuss either strategy—or both!