Building A Diversified Hedged Closed-End Fund Portfolio

by: Alvin Rodolfo


Build a portfolio of closed-end funds using statistical screens.

Hedge the portfolio with inverse ETFs.

CEFs trading a discount to their historical premium/discount to NAV can provide protection in a correction.

With both the equity and bond markets near all-time highs, how would a new investor allocate their capital? Small investors cannot effectively build a diversified portfolio using individual stocks as transaction costs erode returns. Plus, the work involved in following news, earnings, etc. is magnified by the number of stocks needed to build a properly diversified portfolio. The solution is to build a portfolio of closed-end funds and then hedge with inverse exchange traded funds.

I have chosen CEFs as they are actively managed portfolios and there is very little published research, especially coming from the big investment banks. They have long been attractive to individual investors due to their tendency to trade at a discount to Net Asset Value and often pay a substantial dividend. The patient investor can find diamonds in the rough.

My model is mechanical and does not require the investor to forecast economic data or corporate news. I believe that price not only reflects market consensus, but also offers investors opportunities.

How does one go about choosing from the universe of CEFs? Morningstar lists 631 in their universe and they update information daily. Go to the CEF QuickRank page and narrow the universe by selecting various funds by performance and premium/discount statistics. Investors can also use CEF Connect for additional information.

Initially, each CEF is given a Performance Score. The model is weighted onwards long-term performance, but an allowance is made for short-term price movements. Performance is based on NAV growth, not price movement as this may mask changes in the underlying premium/discount (P/D).

The next step is determine the CEF's P/D Score. First, determine the historical premium/discount average. CEFConnect publishes the mean over a number of periods. Use the one that matches your time horizon. Compare this average to the current P/D. For example, if the current P/D is below the average, this will provide a source of appreciation as the P/D will tend to revert to the mean and should provide protection should the market fall.

Combine these two scores to come up with the CEF's Total Score. To prevent going overweight in any one sector, I will choose the highest-ranked CEF in the industry group.

Here is the portfolio ranked by Total Score:

  • Salient Midstream & MLP (NYSE:SMM), 9.1% discount, 5.1% yield
  • DNP Select Income (NYSE:DNP), 4.3% premium, 7.7% yield
  • Cornerstone Progressive (NYSEMKT:CFP), 7.0% premium, 22.4% yield
  • Brookfield Global Infrastruc (NYSE:INF), 10.5% discount, 5.8% yield
  • NexPoint Credit Strategies (NYSE:NHF), 11.8% discount, 6.2% yield
  • Nuveen Real Estate (NYSE:JRS), 4.3% discount, 8.3% yield
  • BlackRock Muni Target (NYSE:BTT), 11.0% discount, 4.9% yield
  • Thai Fund (NYSE:TTF), 12.3% discount, 7.8% yield
  • Delaware Dividend & Income (NYSE:DDF), 9.3% discount, 6.3% yield
  • Nuveen Real Asset (NYSE:JRI), 9.0% discount, 8.4% yield
  • H&Q Life Sciences (NYSE:HQL), 3.0% discount, 8.2% yield

Data Source:

The unweighted average discount of the list is 6.3% with a yield of 8.3%.

Currently, the hedge positions are 10.2% of capital devoted to 3x Inverse ETFs (ProShares UltraPro Short S&P500 (SPXU) and Direxion Daily Small Cap Bear 3X (NYSEARCA:TZA)). 6.7% is allocated to a bearish bond ETF (ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT)). As these ETFs are leveraged, their intra-day price movements often lead to short-term trading opportunities. For more conservative investors, the capital allocated to the ETFs can rest in cash.

In the coming days, I will delve deeper into the model and will present the investment case for each of the funds mentioned.

Disclosure: The author is long SPXU, TZA, TBT, SMM, DNP, CFP, INF, NHF, JRS, BTT, TTF, DDF, JRI, HQL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.