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Are Mutual Fund and ETF Investors Leaving Money on the Table?

We take a look at a tactical closed-end fund investing strategy.

Steven Pikelny, 06/21/2013

No matter what the fund vehicle, Morningstar believes that strong management teams, solid portfolios, low expenses, proven track records, and established parent companies tend to lead to above-average performance over the course of a market cycle. For long-term investors who are willing to hold on to their funds throughout an entire market cycle, confidence in the soundness of these fundamental characteristics could help prevent costly trading errors in volatile markets. This is especially true for closed-end funds, or CEFs: Premiums can turn to discounts in a matter of days, adding significant volatility to share price performance.

Along with the persistent use of leverage, premiums and discounts are turnoffs for many investors, who prefer comparatively simple investment vehicles such as open-end funds and exchange-traded funds. Seasoned CEF investors, however, will note that volatility can also lead to attractive bargains throughout the CEF universe. We've written several recent articles on the topic, highlighting funds we currently believe to be undervalued. With this in mind, an interesting question remaining open to investors is how to take advantage of these prices. Buying a CEF at a three-year wide discount sounds like a good deal at first blush, but many investors are unwilling to take on the unpopular sector exposure where these deals reside.

Nevertheless, even buy-and-hold investors who prefer simpler fund vehicles for the long haul can stand to benefit by tactically adding CEFs to their portfolios at opportune moments. This is especially true for investors who already have exposure to the unpopular sectors. At last week's Morningstar Investment Conference, head of U.S. CEF research Mike Taggart moderated a panel on CEF investing. (You can read the summary here). While some of the discussion revolved around the benefits of long-term CEF investing, two of the panelists focused on using a CEF overlay strategy within their existing portfolios of ETFs and mutual funds. Patrick Galley, portfolio manager of River North Core Opportunity RNCOX, has successfully implemented this strategy to achieve a 5-star rating against its moderate-allocation category.

What Is a CEF Overlay Strategy?
Because many CEFs have very slim trading volumes, an abrupt change in investor sentiment can easily cause share prices to fall faster than the fund's net asset value. As recent market behavior attests, the resulting discounts can persist for several days before narrowing. An overlay strategy attempts to benefit from these potential movements by swapping current holdings for similar CEF holdings when good valuation opportunities present themselves. After CEF discounts contract, one can swap back into the original fund vehicle.

Below we perform this strategy by implementing simple trading rules and simplifying a portfolio down to two funds. Keep in mind that the strategy can be used simultaneously for several different funds across asset classes.

The portfolio has a 100% allocation to long-duration municipal exposure, which it gains through the ETF SPDR Nuveen Barclays Capital Muni Bond TFI. The portfolio also occasionally swaps shares for Nuveen Municipal Opportunity NIO, a large municipal CEF with a similar portfolio. The period covers TFI's launch in September 2007 through last Tuesday, June 11. Whenever NIO's trailing three-year z-statistic falls below -2.00[1], the portfolio rebalances the entirety of its assets into the CEF at the end of the trading day. Once the z-statistic narrows to -1.50, the portfolio switches back to TFI.[2] The overlay portfolio keeps extra cash on hand when allocating to the CEF so as to offset the effects of leverage.[3] The example also omits the effects of trading around the ex-dividend dates, tax implications from realizing gains or losses, and trading costs.

The following graph presents the outcome of the strategy compared against the total returns from TFI and NIO on a share price basis.


  - source: Morningstar Analysts

Steven Pikelny is a closed-end fund analyst at Morningstar.
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