This article was released to members of the Cambridge Income Laboratory 30 days ago.
The inaugural edition of the Chemist's CEF Report is here! I have received feedback from subscribers saying that they were interested in more content regarding CEFs. Therefore I have decided to share, in a systematic format, the screening process that I use to research for CEFs to include in the Cambridge Income Laboratory Portfolio, or for potential CEF arbitrage opportunities.
As I have written about numerous times in the past, taking advantage of the mean reversion of premium/discount reversion is a potential strategy to juice your CEF returns (see "Exploiting Closed-End Fund Discounts" for a recent academic paper on the subject).
Before launching my subscription service, I had written publicly about CEF arbitrage trades in funds such as KYN (NYSE:KYN), DNP (NYSE:DNP), EXG (NYSE:EXG), ETW (NYSE:ETW), all of which achieved a positive return with low risk (due the inherently market-neutral nature of a long/short trade).
In the premium service, the Cambridge Income Laboratory Portfolio has already twice capitalized on mean reversion in its short lifetime (~2.5 months). HIE (NYSE:HIE) was purchased on the Portfolio's inception at a -8.70% discount at the start of July, but in mid-August, its discount had shrunk to about -3%, meaning that the position gained about 5% "for free" simply due to discount contraction. Because of its relative overvaluation (1-year z-score = 2.00), HIE was swapped for EOS (NYSE:EOS) in mid-August, which at the time had a -7.57% discount and a 1-year z-score of -1.00. Barely one month later, EOS now has a -4.18% discount and a 1-year z-score of 1.90, again allowing us to pocket a 3% gain for free. I am now seeking to replace EOS with another fund in the Portfolio!
Because of the extensive amount of data processing and presentation required, the Report will be relatively heavy on figures but light on commentary compared my normal articles. Hopefully this information will be useful to readers in forming their own investment decisions.
I intend to make the Chemist's CEF Report a monthly feature. The inaugural edition has been delayed but I expect that the next feature will be published on October 1st.
A database of CEFs was obtained from CEFAnalyzer. In instances where NAV data was delayed, premium/discount values were manually checked. 546 actively trading CEFs were included in the analysis.
All yields are quoted as the yield on price. All z-scores refer to the 1-year z-score, which I consider to be the most useful time duration for profiting from premium/discount reversion.
1. Top 5 highest premia and top 5 highest discounts
CEFs with the highest discounts are potential buy candidates, while CEFs with the highest premia are potential sell/short candidates. The following data show the 5 CEFs with the highest premia and 5 CEFs with the highest discounts. Yields, z-scores and leverage are shown for comparison.
2. Top 10 highest yield CEFs
Some readers are mostly interested in obtaining income from their CEFs, so the following data presents the top 10 highest yielding CEFs. I've also included the premium/discount and z-score data for reference. Before going out and buying all 10 funds from the list, some words of caution: [i] higher yields generally indicate higher risk, [ii] some of these funds trade at a premium, meaning you will be buying them at a price higher than the intrinsic value of the assets (which is why I've included the premium/discount and z-score data for consideration), and [iii] beware of funds paying out high yields from return of capital in a destructive manner.
*The premium/discount an z-score data may be unreliable as those funds report NAV values only infrequently.
3. Best combination of yield and discount
For possible buy candidates, it is probably a good idea to consider both yield and discount. Buying a CEF with both a high yield and discount not only gives you the opportunity to capitalize from discount contraction, but you also get "free" alpha every time the distribution is paid out. This is because paying out a distribution is effectively the same as liquidating the fund at NAV and returning the capital to the unitholders. I considered several ways to rank CEFs by a composite metric of both yield and discount. The simplest would be yield + discount, however I disregarded this because yields and discounts may have different ranges of absolute values and a sum would be biased towards the larger set of values. I finally settled on the multiplicative product, yield x discount. This is because I consider a CEF with 7% yield and 7% discount to be more desirable than a fund with 2% yield and 12% discount, or 12% yield and 2% discount, even though each pair of quantities sum to 14%. Multiplying yield and discount together biases towards funds with both high yield and discount.
|CEF||Premium/discount||Yield||z-score||Leverage||D x Y|
4. Best combination of yield, discount and z-score
This is my favorite section because it takes into account all three factors that I always consider when buying or selling CEFs: yield, discount and z-score. The composite metric simply multiplies the three quantities together. A screen is applied to only include CEFs with a negative 1-year z-score.
|CEF||Premium/discount||Yield||z-score||Leverage||D x Y x Z|
5. Summary statistics
The average premium/discount of all the CEFs in the database is -4.57%. The following boxplot shows lower quartile, median and upper quartile data (the mean is indicated as the "x").
The average distribution yield of all the CEFs in the database is 6.68%.
The average z-score of all the CEFs in the database is 0.78.
As I have discussed a number of times recently, I consider income assets to be quite overheated in today's market. CEFs are no exception, with the average z-score being 0.78, despite the average premium being -4.57%. I don't see any screaming buys in the CEF universe right now.
I intend to give a list of my top 3 CEF picks each month, which is based on my consideration of the data, as well as some subjective judgement. Note that me designating a fund as a top pick does not mean I am encouraging subscribers to buy the fund, nor am I necessarily going to include the fund in the Cambridge Income Laboratory Portfolio. Moreover, note that some of the picks may have a narrow mandate (e.g. utilities stocks or MLPs), and therefore each investor should consider their own investment objective and risk tolerance before deciding to invest money into any of the picks.
For September, my top 3 picks are:
- UTG Reaves Utility Income [UTG]: 6.0% yield, -8.9% premium/discount, -1.12 z-score, 22.6% leverage.
- ClearBridge American Energy MLP [CBA]: 9.2% yield, -10.0% premium/discount, -0.71 z-score, 24.9% leverage.
- Macquarie/First Trust Global Infrastructure/Utilities Dividend & Income Fund (NYSE:MFD): 10.7% yield, -9.7% discount, -0.39 z-score, 25.5% leverage.
The three picks have a decent combination of yield, premium/discount and z-score values.
Please feel free to present suggestions on what else you would like to include in the Report. I hope this information has been useful for CEF investors.
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Disclosure: I am/we are long UTG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.