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Closed End Fund Arbitrage

The March edition of Bloomberg Markets magazine contained an article about Northbrook, Illinois based Relative Value Partners LLC.  The article describes the investment tools used by Relative Value Partners which include ETF’s and closed end funds, as well as some tactical investment approaches used by their absolute return strategy.  In detail, “As of the end of January, for instance, the correlation, or beta, of the NFJ Dividend, Interest and Premium Strategy Fund managed by Allianz Global Investors to the SPDR Trust Series 1 exchange-traded fund -- a proxy for the S&P 500 -- was 0.905.  “That would tell you how many SPDRs to sell to hedge this security,” Fertig says. “If we bought $100,000 of this, we’d short about $90,000 of SPDRs.” 

Read the full article

The article is vindication to our strategy piece from July 8, 2009.  In July, hETFund described a similar approach, and now we add a new tactic of protective puts in order to enhance yield.  First, we review the mechanics used in Fertig’s idea.  NFJ recently traded at a 16% discount to its net asset value with an annual yield of 4.2%.  About three quarters of the fund are equities with the remaining assets in corporate bonds and preferred shares.  In the periods ending over the past 6 months, 1 year, and 2 years, NFJ maintained a correlation with SPY of 88%, 82% and 80%, respectively.  However, the net asset value of NFJ held a tighter correlation with SPY of 95% in all of those periods.


State Street Global Advisors SPDR ETF (NYSEARCA:SPY)

  • SPY recently traded at $105.89, and has a current payout ratio of 2.23%.
  • SPY tracks the price and yield performance of the S&P 500 Index.  This ETF has net assets of $79.6 billion.
  • Strategy: if you own a closed end fund like the one described above worth $100,000, then you could sell short 850 shares of SPY to create a market value neutral position and sell 8 put options struck 10% out of the money.  The short sale of 850 shares is about $90,000 market value. 
  • The net yield of the position is 1.97% after paying a 2.33% dividend on SPY.  The April 17, 2010 expiry with a $96 strike is 10% out of the money, and this recently traded at a $1.58 premium.  On an annual basis, the 10% out of the money position yields 8.4%, thus the net yield of the position is 10.4%, before management fees of the funds.
  • Risks: 1) correlation with a closed end fund can change over time, 2) reduced volatility will cause a decline in future call option premiums and lower annualized yield of the strategy, 3) bi-monthly maintenance of the option position, or 4) if the put options were exercised in a bear market then the short position will no longer hedge the closed end fund.

Disclosure: Long & short SPY