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

by: David Jackson

The ETF Investor article about arbitrage opportunities between closed-end funds (CEFs) and ETFs generated considerable interest. The article raised the possibility that, with closed-end REIT funds such as NRO, RTU, SRO, and SRQ trading at significant discounts to net asset value, investors could consider an arbitrage trade: long the closed-end funds, with offsetting short positions in one or more of the REIT ETFs ICF, IYR, and RWR.

The article attracted some thoughtful and interesting feedback. Jay Buster pointed out that you can arbitrage the spread between CEFs and ETFs by selling short CEFs trading above net asset value (NYSE:NAV). Lawrence Mouskoph argued that "The discounts on the REIT CEF’s keep getting wider and wider... Who’s to say the discounts might not go up to 25%, maybe 30%, maybe 40%?". And the team that produces CEF Orphan wrote the following analysis of the Neuberger Berman Real Estate Securities Income Fund (NYSEMKT:NRO) and the Cohen & Steers REIT and Utility Income (RTU), which is worth reading for anyone who owns those funds:

Your "Arbitrage Opportunities Between Closed-End Funds and ETFs" was very thought provoking and demonstrates your sound understanding of these two types of investments. We would like to provide some additional "food for thought" concerning this trade.

It appears to us that this trade could also be called a "Bet the CEF Discount Will Narrow Enough to Profit After Bid/Ask Spreads, Trading Costs and Lost Opportunity Costs." As most everyone knows, CEF discounts are an odd and complex phenomenon. Many CEF discounts are persistent and can increase over time. This can occur for many reasons. We'll focus on two of the CEFs you mentioned to illustrate our point.

Let's start with Neuberger Berman Real Estate Securities Income Fund (NRO). In our opinion, the managers of this fund are not shareholder friendly. Please see the Neuberger shareholder issue described on December 20, 2005
( ). When investors feel a CEF fund manager is not looking out for their best interests the fund's discount tends to widen and stay persistent.

Now on to Cohen & Steers REIT and Utility Income (RTU). This fund has a "return of capital component (NYSE:ROC)" that many investors feel amounts to a return of your own money with some significant tax complications if the fund is held in a taxable account. Also, when ROC is included in a fund's "yield" it can artificially inflate the "yield." When investors realize the "yield" they are receiving is really a ROC they can become disallusioned and the fund's discount tends to widen and stay persistent.

Another issue relates to margin interest for the shorted ETF and the need for the holder of the short position to pay the ETF's dividends. Of course most everyone understands the profit friction that is enountered with bid/ask spreads, commissions and lost opportunity costs.

Thank you very much for your post and for the ETFInvestor blog!
The Team

Thanks to all the commenters for these valuable contributions.