We all love a good sale especially when investing in financial assets. Unfortunately, discounts do not come around often, but with a relative value approach we only need one asset to be discounted with respect to another.
Nowhere is this truer than with closed end funds (NYSEMKT:CEF). Many CEFs trade at a discount to NAV. The problem is that discounts can become greater discounts so timing a long only strategy is difficult. With a long / short strategy timing error is reduced.
I tested this approach using a back-testing application in the Bloomberg's App Store called Strategy Explorer, developed by IntuQuant (www.intuquant.com). Using a universe 256 US based CEF with sensible liquidity, I calculate the discount to NAV on a daily basis for the last 5 years. Distributing the CEFs into equally populated deciles according to their discounts, I buy the cheapest and short the richest. Annual return for this strategy is 18.8% with a Sharpe ratio of 1.4. If I rebalance weekly, annual return is 17.5% and Sharpe ratio is 1.3. Monthly rebalances product a return of 14.7% with a Sharpe of 1.1.
This is a respectable result for a long / short strategy in a rising market. These results do not factor in transactions costs or locate limitations. However, even better returns are attainable with less diversification and smarted weightings. Currently, this screen wants to be long CTF, NRO, PEO and short PHK, GUT, MAV.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.