Step Zero: Your Portfolio
You know about the potential advantages of buying funds at a big discount to NAV, you’ve learned about Z-scores, and you’ve read about where the bodies are buried when it comes to basic CEF due diligence… now what? It’s tempting to adopt of strategy of going after the most heavily-discounted CEFs with the most negative Z-scores loaded for bear. While this approach has some merit, one should lose sight neither of his/her investment goals nor of basic, time-tested investment principles.
CEF Alpha believes that CEF investors should hold a core portfolio consisting of a globally-diversified equity component and a high-quality fixed-income component. We’re fans of the time-tested strategy of buying-and-holding low-cost index ETFs and mutual funds, and are generally skeptical of actively-managed funds and market-timing. The fact that you’ve found a CEF yielding 25% that holds Brazilian floating-rate convertible bonds and is trading at a 35% discount to NAV with a three-year Z-score of -4.50 doesn’t mean you should abandon your core portfolio and pile in.
Step One: Wait
Opportunistic investing using CEFs is, well… opportunistic. Just as you can’t count on finding a smoking deal every time you visit a thrift shop, you can’t expect to find a smoking deal on a CEF every time you set out to find one. Generally speaking, funds develop big discounts when people dump shares of CEFs indiscriminately. Indiscriminate selling is usually a byproduct of investor fear.
CEF Alpha’s advice is to refrain from tinkering with your (hopefully broadly diversified, low cost, buy-and-hold) portfolio until opportunity comes knocking. That knock may come in the form of a major broad-market correction, or in the form of a melt-down confined to a single asset-class. CEF Alpha’s indices can help you identify when certain asset classes as a whole are developing hefty discounts. Our dashboards can help you hone-in on particular funds within an asset class that may present an especially good value based on discount and z-score.
You don’t necessarily have to scan our indices and dashboards everyday in order spot opportunities (although we’d love for you to!). Even the most casual follower of CNBC, Yahoo! Finance, Seeking Alpha, or the Wall Street Journal will usually see plenty of headlines about how an asset class is “tanking” or “collapsing”, which can tip him off that it may be time to look for opportunistic CEF investments within said asset class.
Step Two: “Sub-In” Opportunistic CEFs
When opportunity within an asset class finally does come knocking, we recommended “subbing-in” a basket of 2-5 opportunistic CEFs of the same asset class. That is, replace (or partially replace) the low-cost index fund you were using to gain exposure to the asset class with a handful of CEFs that will provide exposure to the same asset class. Since CEFs tend to be actively managed, the benefit of using multiple CEFs to replace the index fund is that, together, they should dilute some of the extra noise, or tracking error, that results from using a single active fund.
There are a two important considerations to keep in mind when using this “subbing-in” strategy:
1. You should beware of potential tax consequences associated with the index fund-to-CEF switch-a-roo, as well as potential tax consequences in the future when you reverse the trade (see Step Three). Realizing gains (especially short-term gains) can take a big bite out of your profits, perhaps so much so that pursuing this strategy isn’t worth it, regardless of how beaten-down the CEFs you want to buy are. Carefully consider your tax situation and consider consulting a CPA before you go down this path. Also consider isolating your CEF adventures to a tax-deferred or tax-exempt account like an IRA or Roth IRA.
2. Don’t forget that CEFs are not always the prettiest investment creatures. In order for a CEF to truly be worthy of “subbing-in” to your portfolio, you should be reasonably assured that you are buying it an enough of an absolute and relative (Z-score) discount that you will be more than compensated for the higher fees and potentially extra risk associated with the CEF as the fund’s discount (hopefully) reverts to its longer-run average discount over several months or years.
Step Three: Unwind It
Every opportunistic adventure must come to an end eventually. The decision to unwind the “sub-in” maneuver and reinstate the original index fund for an asset class should be based on whether the reasons for entering the individual CEFs still remain — not on whether you’ve made “enough” money on the investments. The best indication of whether to exit a CEF is probably found by examining the fund’s Z-score. If a fund’s Z-score has climbed back toward zero, it’s a good indication that it may be time to divest. The original investment thesis depended on earning an incremental return over the regular asset class return as the discount of the fund shrank. If the Z-score is close to 0, there is less of a reason to assume that the discount will shrink since it has already mean-reverted.