Underperforming Closed End Funds: A Hedging Strategy?

| About: iShares Morningstar (JKK)

I have been running my portfolios at about 0-20% net long (long exposure minus short exposure) for the last year, largely in accordance with Hussman's hedging strategy which has, over a full cycle, generally outperformed an unhedged strategy and with less volatility.

I make some modifications--most notably shorting individual securities rather than his puts strategy, which I believe affords similar downside protection while allowing for the possibility of returns on the short-side, as well.

Unfortunately, I don't have enough ideas on the short side to fully hedge my portfolio, so I usually end up just shorting the indexes, or a ETF I believe will underperform [e.g. iShares Morningstar Small Growth (NYSEARCA:JKK) or DJ Wilshire REIT (NYSEARCA:RWR)]. When doing this, I look for a sector that I believe is overpriced, and then find the worst ETF I can in that sector.

This has had its intended effect, but a light bulb recently went off in my head, and suggested a strategy that may be more effective. I believe shorting poor CEFs can be a more attractive way to hedge out market risk than shorting indexes, in the same way shorting a historically poor performing mutual fund would have been better than shorting indexes. If you are not familiar with CEFs, I suggest reading this article and this. Otherwise, I have summarized:

Closed end funds are similar to mutual funds (open-ended funds) in that they are pooled capital managed by a portfolio manager. The difference is that open-ended funds IPO to raise capital, and subsequently trade like stocks in a market based on supply and demand, whereas Mutual funds constantly issue and cancel shares as investors buy and redeem their shares. Because CEFs trade in a supply and demand market, the market price can become detached from the net asset value [NAV] of the underlying holdings. This is referred to as the premium or discount a fund trades at, and is usually driven by past returns and the dividend yield. This structure also means you can short CEFs, which you cannot do with mutual funds.

Shorting CEFs, in my opinion, has a few benefits over shorting ETFs:

1) Fees are higher, creating an increased hurdle to achieving returns above the market. It is not uncommon for smaller CEFs to have management fees of about 1-2%, and expenses of about 2-3%, resulting in a 5% hurdle out the gate.
2) Most CEFs have less incentive to perform well than do mutual funds. When mutual fund shares are redeemed, the mutual fund company loses assets, but because CEFs raise money at the start of a fund they don't have the same concern. If investors are not satisfied, they do not get their money back from the fund, but on the market by selling shares to another investors. The company does not experience an outflow, and thus does not care much about a discount. Good CEFs do care about their reputation and ability to raise future capital, but luckily their are plenty of bad ones out there that don't seem to mind poor performance.
3) CEFs have less incentive to replace underperforming managers, assuming their fees are calculated as a percentage of assets (as most are). Many are happy to collect 2% of $50M indefinitely while exerting zero effort, rather than grow that a couple percent a year extra and have to work for it.
4) High volatility CEFs and/or those that underperform the market typically swing to a discount when the market heads south. In this case, you can profit both off the decrease in the NAV, but also in the increasing gap between the market and NAV price. Many high flying emerging market ETFs, for example, are trading at 5%+ premiums. In the event the NAV dropped 20%, and the 5% premium became a 5% discount, your profit would be 29% (a 20% from the NAV decline, + 9% with the premium contraction).

Next week I will do more work on profiling some of the more shameful CEFs that I plan on adding as short positions in my accounts as a hedge against market fluctuations.