Our spiritual leader and provider of initial guidance in the financial markets - 'Arbitrage Trader' - did not pick this nickname without a good reason. Through years of experience and strive for superior risk-adjusted returns, he figured out that with a decent amount of fundamental knowledge and simple statistics one can use Closed-end Funds as vehicles for arbitrage trading, something light years away from the purpose which they are intended to serve.
In spite of the sense of comfort which one might feel from the previous paragraph, make no mistake by thinking that this approach leaves you without scars and wild trading-related stories to share with fellow market participants. Fortunately, over time we have somewhat learned how to avoid disasters while applying this methodology and, moreover, when the time is nigh to share our ideas with the Seeking Alpha audience - the tipping point where it becomes relatively hard to lose money unless the inherent dangers of Short selling rear their ugly heads.
This article will briefly acquaint you with a CEF which, in our humble opinion, is overvalued at a point in time when the probability of a dividend cut is relatively high. And here is where we must emphasize that one must NOT mistake 'high yield' for actual performance in the context of funds invested in Fixed Income.
The star of this piece is the Stone Harbor Emerging Markets Income Fund (EDF) and before even introducing it I would like to note that everything presented here is about the market dynamics around the CEF. I have absolutely no opinion about the management team or how well they do their job. In this kind of articles all you should care about is the degree to which Mr. Market might be making a significant mistake and creating a mispricing to the delight of active traders.
To acquaint you with EDF, in case you have not heard of it, I will be referring to its dedicated website and CEFConnect.
The Fund's primary investment objective is to maximize total return, which consists of income on its investments and capital appreciation. The Fund will normally invest at least 80% of its net assets (plus any borrowings made for investment purposes) in Emerging Markets Securities. "Emerging Markets Securities" include fixed income securities and other instruments (including derivatives) that are economically tied to emerging market countries, that are denominated in the predominant currency of the local market of an emerging market country or whose performance is linked to those countries' markets, currencies, economies or ability to repay loans. A security or instrument is economically tied to an emerging market country if it is principally traded on the country's securities markets or if the issuer is organized or principally operates in the country, derives a majority of its income from its operations within the country or has a majority of its assets within the country. There is no assurance that the Fund will achieve its investment objective.
Yes, this is one of these closed-end funds which provide access to a niche of the global market which individual investors do not have many gateways to. Therefore anyone who did not know about its existence can put it up on their radar, but bear with me.
Below you can see the Top 10 holdings as per CEFConnect (9/30/2018 - Q3), but in reality I would classify the information there as insufficient for any prudent investor, therefore you can follow this link to the fund sponsor's website in order to see the full list of holdings as per Q4.
The objective of this article is not to delve into the fund's portfolio and will not pay any attention to it. My only observation is that it is well-diversified and contains a fair degree of toxicity, but this is something one should expect to encounter when dealing with emerging markets.
Another factor the income investor crowd pays attention to are the fees which a CEF pays its management, leverage and so on. As an active trader I do not really care about these, yet here they are as per CEFConnect:
Of course, we cannot forget to take a glimpse at the level of Leverage the fund managers have chosen as it ultimately will have an impact on the volatility we encounter, should our horizon lean towards the long term:
I cannot comment on whether this is high or low, but in my humble opinion it is somewhere around the mean you would encounter if taking into consideration the whole closed-end fund universe. Leverage is so common in these vehicles, that it is almost rare to find one where the managers have refrained from utilizing it.
The aforementioned metric inevitable sets up the stage for a brief recap of the historical and current distributions of Stone Harbor Emerging Markets Income Fund (EDF):
Extremely generous, perhaps a bit too much? I am tempted to jump the gun, but according to all trading-related books discipline is essential, so you will have to scroll down a bit further.
The highlight from the snapshot provided above is that a decent portion of the distributions shareholders of EDF have received consisted of ROC (Return of Capital). What does this mean? Effectively you are being given back your own money - which is still something - and the Cost Basis of your investment in this instrument is being lowered at the same pace. This portion of the dividend is not subjected to taxation, as far as I know and according to common sense. However, there is a catch - if you are consistently receiving ROC from a Fixed Income CEF, then there is relatively high probability that the underlying portfolio is not having a good time. (Read as: Not performing at the level it was intended to when the fund managers were determining the dividend size.)
Two metrics, only one of which is commonly looked at by the majority, are Current Yield (derived from the Market Price) and Yield on NAV - Net Asset Value:
Source: Author's Excel Magic
I completely understand the excitement one may go through when yields of this magnitude pop on their radar, but it is crucial to understand that it does not stand for much and is subject to a "reality check" in most cases.
Performance And Sentiment
Closed-end funds are unique products in the sense that one can measure the sentiment towards a certain sector by looking at the Discount or Premium of a group of vehicles invested in it. Of course, those whose portfolio contains products to which the small investor has no access usually deserve a certain degree of Premium simply because they saturate a niche. Arguably Stone Harbor Emerging Markets Income Fund is among the aforementioned.
From this point on, you can consider the word "sentiment" almost interchangeable with "Premium / Discount," while taking into consideration the context. And our objective, as arbitrageurs is to capitalize on deviations in sentiment which also make sense from a fundamental standpoint. Therefore, the next step is a brief examination of the historical Premium/Discount averages at which EDF has traded.
What you are seeing above is a 5-year chart of EDF and XEDFX (the ticker which represents the Net Asset Value - NAV). The spread between the Market Price and the NAV is put into numbers with the Premium/Discount metric. And this is the user-friendly way of visualizing it - one does not even need to see the numbers to figure out that there is something unusual on the chart above.
I might have jumped the gun to a certain extent, but all that matters is that the dots have been connected by the concluding sentences of the article.
Along the way I should have mentioned that portfolio performance is what we should truly care about, instead of pretty Current Yield numbers, or at least I hope that I did so. The numbers below elaborate on this matter:
Is your monthly distribution coming from the Market Price? No, not really and it turns out that this article's shining star is not so bright after all.
My tone is changing as we progress and it is high time for us to get to the point:
The go-to place for these metrics is CEFConnect for me personally, but at the time of writing this article they have decided that providing us with a free update of the most recent Market Price/NAV numbers is not among their priorities and MorningStar are kind enough to fill this void to a certain extent.
In what some may see as a "smiley face," others will take note of the stark difference between the 3-year Average Discount/Premium and the latest Discount/Premium figures - there is a "little" difference between the numbers. Simple mathematics which I need not do for you. CEFConnect's almost up-to-date numbers provide us with the 52-week Average Premium/Discount:
As Master Arbitrageurs we tend to pay more attention to the 52-week average (1-year) as a point of reference when seeking the relatively inevitable revert to mean. I am not entirely fluent in Statistics, thus I like to keep them Simple, but a revert to mean in Stone Harbor Emerging Markets Income Fund's (EDF) case would occur if the current Premium (32.18% as of 4/11/19) shrinks to about 15.17% (the 52-week average as of 4/9/19).
Albeit I do not place a whole lot of importance on it while doing my daily scanning in the CEF universe, some may be interested in the Market Price performance and the Volume which accompanies it, therefore a mandatory screenshot of these is available below:
As you can see, there is not much value to be found here. If EDF was the common stock of a company and not a closed-end fund with a gravitational pull towards its Net Asset Value, then this chart could have been useful. There is what we may refer to as "elevated volume" over the last week, or so, to the upside but from my perspective this is proof that being in possession of large amounts of capital does not necessarily transform us into "smart money."
In order to seize an arbitrage opportunity, even if there is a potential catalyst, it is considered wise to find a benchmark and establish a pair trade in order to avoid directional risk. Put in other words, while I am interested in betting against a further increase in EDF's Premium, I am not willing to bet against its NAV appreciating. Therefore I must find a way to replicate the underlying portfolio through another instrument available on the market.
Avid readers have likely noticed that our proprietary software is no longer what it used to be and we no longer have the precious dividend-adjusted NAV data available, thus the following screenshots may seem a bit vague, but I will do my best to elaborate on the matter and any questions you might have shall be answered.
The logical go-to suspect is iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB). This exchange-traded fund is likely going to be the perfect match for EDF in a pair trade scenario. Due to the aforementioned difficulties we are facing, I will be examining the correlation between EDF and EMB on a 800-day time frame - it is going to clear out any noise created by shifts in sentiment and deviations in the Premium/Discount:
The purpose of this exercise is to figure out whether on a larger time frame these two are correlated. In Statistics we trust and 93% correlation is not to be taken lightly. I am not uncertain that if we plug in XEDFX (the fund's NAV), the number is going to be about the same.
Long story short: EMB is going to suffice.
Jumping the gun has proven to be an issue, so those of you familiar with CEFs have likely figured out the direction in which we are headed. However, it would be inappropriate if I did not sum up all arguments I hinted at with an explanation which effectively "seals the deal" as far as my opinion on Stone Harbor Emerging Markets Income Fund goes.
- Simple Statistics: EDF is trading at a 30+% Premium, which is 15% above its 52-week average and about 27% above its 3-year average Premium.- Argument: A revert to mean, even if partial, should occur in the near term and market conditions, or fundamental catalysts, may drive it to a full revert to mean at least on a 1-year time frame.
- Fundamentals: I highlighted earlier that a huge portion of the distributions provided by EDF consist of ROC (Return of Capital) which means that it is not "earning" the dividends. In a perfect CEF world, a consistent presence of ROC in a Fixed Income CEF's distributions translates into a dividend cut sooner or later. - Argument: EDF's distribution rate should be declared by the fund managers between the 15th and 25th of April, and I believe that Mr. Market is underestimating the possibility of a dividend cut. This I would consider as a catalyst for a full revert to mean.
- The Trend: Anyone who keeps an eye on the CEF universe has taken note of several notable dividend cuts which took place this month - PHK, PGP, RCS, NCZ, NCV - all in funds whose distributions contained a fairly large percentage of ROC.
I am not entirely sure how convincing this may seem to those of you who are not as involved as me and the traders around me. However, I believe that this cluster of factors is sufficient to build the case about establishing a pair trade in which we are Short EDF.
In order to avoid significant directional risk, I have determined the following ratio as comfortable:
- Short: 1000 EDF
- Long: 100 EMB
As you are likely to notice, I am not using a statistical model but merely replicating the Net Asset Value of my position via EMB (the ETF). The position size in EMB is based on the "market value" of the NAV and as a result of this the directional risk is mitigated to neglected levels.
The idea is fairly obvious - we want to have a Short position in EDF when the dividends are declared and potentially capitalize on the revert to mean relatively fast in case there is a distribution cut. In case this does not happen, the pair trade is heavily dependent on Short Margin Interest fees and how fast a "normal" revert to mean might occur.
At 'Trade With Beta' we constantly monitor the CEF universe and seek actionable mispricings, and opportunities in any shape. Multiple members managed to capitalize on the dividend reductions in the funds we mentioned earlier by applying the same logic and we are inclined to believe that common sense might prevail and EDF will have its insane Premium shredded by a dividend cut.
It is important to note that if you are an income investor and have had this friend in your portfolio up until the moment you read this article, the probability that you will preserve capital by exiting, and later on re-establishing, your position is relatively high.
Trade With Beta
At Trade With Beta, we also pay close attention to closed-end funds and are always keeping an eye on them for directional and arbitrage opportunities created by market price deviations. As you can guess, timing is crucial in these kinds of trades; therefore, you are welcome to join us for early access and the discussions accompanying these kinds of trades.
Disclosure: I am/we are short EDF. 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.
Additional disclosure: I am/we are Long EMB (10 shares for each 100 shares Short in EDF).