Saturday, June 2, 2007

Underperforming CEFs as a hedging strategy?

I have been running my portfolios at about 0-20% net long (long exposure minus short exposure) for the last year, largely in accordance with Hussman's hedging strategy which has, over a full cycle, generally outperformed an unhedged strategy and with less volatility. I make some modifications--most notably shorting individual securities rather than his puts strategy, which I believe affords similar downside protection while allowing for the possibility of returns on the short-side, as well.

Unfortunately, I don't have enough ideas on the short side to fully hedge my portfolio, so I usually end up just shorting the indexes, or a ETF I believe will underperform (e.g. JKK or RWR). When doing this, I look for a sector that I believe is overpriced, and then find the worst ETF I can in that sector. This has had its intended effect, but a lightbulb recently went off in my head, and suggested a strategy that may be more effective. I believe shorting poor CEFs can be a more attractive way to hedge out market risk than shorting indexes, in the same way shorting a historically poor performing mutual fund would have been better than shorting indexes. If you are not familar with CEFs, I suggest reading this article and this. Otherwise, I have summarized:

Closed end funds are similar to mutual funds (open-ended funds) in that they are pooled capital managed by a portfolio manager. The difference is that Open-ended funds IPO to raise capital, and subsequently trade like stocks in a market based on supply and demand, whereas Mutual funds constantly issue and cancel shares as investors buy and redeem their shares. Because CEFs trade in a suply and demand market, the market price can become detached from the net asset value (NAV) of the underlying holdings. This is referred to as the premium or discount a fund trades at, and is usually driven by past returns and the dividend yield. This structure also means you can short CEFs, which you cannot do with mutual funds.

Shorting CEFs, in my opinion, has a few benefits over shorting ETFs:
1) Fees are higher, creating an increased hurdle to achieving returns above the market. It is not uncommon for smaller CEFs to have management fees of abou 1-2%, and expenses of about 2-3%, resulting in a 5% hurdle out the gate.
2) Most CEFs have less incentive to perform well than do mutual funds. When mutual fund shares are redeemed, the mutual fund company loses assets, but because CEFs raise money at the start of a fund they don't have the same concern. If investors are not satisfied, they do not get their money back from the fund, but on the market by selling shares to another investors. The company does not experience an outflow, and thus does not care much about a discount. Good CEFs do care about their reputation and ability to raise future capital, but luckily their are plenty of bad ones out there that don't seem to mind poor performance.
3) CEFs have less incentive to replace underperforming managers, assuming their fees are calculated as a percentage of assets (as most are). Many are happy to collect 2% of $50M indefinitely while exerting zero effort, rather than grow that a couple percent a year extra and have to work for it.
4) High volatility CEFs and/or those that underperform the market typically swing to a discount when the market heads south. In this case, you can profit both off the decrease in the NAV, but also in the increasing gap between the market and NAV price. Many high flying emerging market ETFs, for example, are trading at 5%+ premiums. In the event the NAV dropped 20%, and the 5% premium became a 5% discount, your profit would be 29% (a 20% from the NAV decline, + 9% with the premium contraction).

Next week I will do more work on profiling some of the more shameful CEFs that I plan on adding as short positions in my accounts as a hedge against market fluctuations.


Jeremy said...

While shorting CEFs may be a way to take advantage of higher expense ratios and potentially capture narrowing premiums and widening discounts there are also unmentioned downsides. First, the additional layer of premium/discount risk. Typically CEFs trading at a discount offer some downside protection during market declines, i.e. the market price falls less than the NAV in a down market narrowing the discount. Secondly, CEFs commonly pay high distributions as often as monthly which would have to be covered by the short seller. Finally, unlike an ETF which provides a market maker, CEF shares must be borrowed from a shareholder just like a common stock; in less liquid funds (read the poor performers you would want to short) it may be difficult to find the shares. Additionally in these less liquid funds there is a wider bid/ask spread detracting from performance.

With this in mind even if you are looking for a broad based short you may be better looking to shorting a high expense ETF, buying an inverse market ETF, or moving into the futures market.

Research Intensive Investing said...

Hi Jeremy,

Thanks for the comment. I agree with many of the concerns you brought up, and thought I would address point by point:

1) Discount/Premium risk--I am looking at chronic underperformers that have a relatively tight NAV/premium range, and have historically gone down more than their NAV in market drops. Still a risk, but only over short periods of time, and should work in my favor in bad times.
2) On high distributions, this is true mostly of the income funds, but less so of the stock funds, which sometimes pay dividends in stock, but that's meaningless. Anyhow, as long as the total returns are poor, it should not matter how that is distributed between capital appreciation and dividends.
3) Most the CEFs I'm looking at have virtually no short interest, so borrowing should not be an issue.
4) bid/ask spread is a good point, though I'm trying to look at some of the more liquid ones

The other ideas you mentioned are possible options but, for various reasons cited in the initial write-up, I believe CEFs may be a more favorable way to play this.