Arbitrage Opportunities Between Closed-End Funds and ETFs (ETFs: ICF, IYR, RWR; CEFs: NRO, RRE, RTU, SRO, SRQ)

 |  Includes: ICF, IYR, NRO, RRE, RTU, RWR, SRO, SRQ
by: David Jackson

Exchange-traded funds (ETFs) have clear advantages over closed-end funds (CEFs). They are generally index funds (versus actively managed funds for CEFs), and we know that index funds tend to outperform actively managed funds over time. They tend to have lower expense ratios. And due to their growing popularity, they tend to be more liquid than closed-end funds. Because of these advantages, ETFs are displacing CEFs for many asset classes.

But this actually leads to interesting opportunities for ETF and CEF investors. Their structure means that ETFs don't trade at discounts or premiums to net asset value over sustained periods of time, unlike CEFs. And that means that sometimes a CEF will trade at a discount to net asset value and a similar ETF won't.

There are intriguing trading opportunities for investors who spot relative-to-asset-value disparities between CEFs and ETFs. The most obvious: buy CEFs trading at deep discounts to net asset value, and sell short an equal dollar value of an ETF that tracks the same sector.

The key advantage of this strategy is that the investor has no market risk -- this is effectively a market neutral hedge fund following an arbitrage strategy. The key risk is that the CEF's discount to net asset value won't close, and the investor won't make money. Perhaps the CEF's discount to net asset value is justifiable, for example if the fund manager consistently underperforms his index or the annual fee on the CEF is so high that the CEF price has to discount that.

I use a simple screen to find CEFs trading at discounts to net asset value. Most of the funds that track CEFs allow you to rank them by discount, such as this screen from ETF Connect.

Looking at current CEF discounts, one opportunity leaps out. Real estate (REIT) closed-end funds are currently trading at deep discounts to net asset value. For example, the latest data available as I write this shows the following approximate discounts:

  • Scudder Real Estate Fund II (SRO) -- 18% discount
  • Cohen & Steers REIT and Utility Income (RTU) -- 18% discount
  • Neuberger Berman Real Estate Securities Income Fund (NRO) -- 18% discount
  • AIM Select Real Estate Income Fund (RRE) -- 18% discount
  • Scudder Real Estate Fund (SRQ) -- 17% discount

The ETFs that track the REIT market generally don't trade at sustained discounts over time. They are the streetTRACKS Wilshire REIT Index Fund (RWR), the iShares Cohen & Steers Realty Majors Fund (ICF) and the iShares Dow Jones U.S Real Estate Index Fund (IYR).

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