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Summary Mean reversion in CEFs can be exploited for small gains in portfolio performance. A previous article successfully capitalized on a premium/discount discrepancy between EXG and ETW. The current article identifies another potential opportunity to buy EXG (and sell ETW). Around one year ago, I wrote an article entitled ” Should You Sell ETW And Buy EXG? ” that described a pairs trading opportunity for these two funds. The Tax-Managed Global Buy-Write Opportunities Fund (NYSE: ETW ) and the Tax-Managed Global Diversified Equity Income Fund (NYSE: EXG ) are both global option income close-ended funds (CEFs) from Eaton Vance (NYSE: EV ). The main difference between the two CEFs is that ETW has around 100% option coverage while EXG has around 50% option coverage, with ETW therefore being the more defensive of the two funds. Both funds seek to achieve “current income with capital appreciation through investment in global common stock and through utilizing a covered call and options strategy.” See my previous article for further comparison regarding those two funds. The thesis of the pairs trade was based on the fact that ETW’s discount had narrowed to -3.31% (1-year premium/discount: -7.71%), while EXG’s discount remained high at -8.45% (1-year premium/discount: -8.33%). As was seen in a follow-up article ” Closing The EXG-ETW Pairs Trade “, the discount for ETW had widened from -3.31% to -3.93% while the discount for EXG had narrowed from -8.45% to -5.60%, leading to a gain of ~3% in 6 weeks (~23% annualized). While ~3% over six weeks doesn’t seem much, keep in mind that i) this works out to be ~23% annualized , and ii) this was a “dollar-neutral” trade , in that I merely sold my existing holdings of ETW and used the proceeds to buy EXG, while keeping the total dollar value of the investment constant. Had I held onto the trade for a bit longer, the EXG:ETW pair could have returned even more, up to ~12%. (click to enlarge) The mean reversion of CEF premium/discounts is something that has been documented in the literature (e.g. Patro et al. ). At the same time, a pairs trading strategy reduces risk by making dollar-neutral trades. Indeed, the similarity of EXG and ETW has made the EXG:ETW ratio trade within a tight range of ~10% for the past five years, as can be seen from the graph below. Highs in the graph represent good times to sell EXG and buy ETW, while lows in the graph represent good times to buy EXG and sell ETW. (click to enlarge) Current opportunity The chart above shows that the EXG:ETW ratio has again sank to the lower bound of the trading range. Why has this happened? As can be seen from the chart below, despite tracking each other closely for around ten months since October of last year, there has been a sudden dislocation of the price of the two funds over the past two months. EXG data by YCharts Most of this price disconnect is due to differential premium/discount behavior of the two funds. Over the past 3 months, EXG’s NAV total return was -4.74%, while its price total return was -10.44% (source: CEFConnect ). On the other hand, ETW’s NAV total return was -4.12%, while its price total return was “only” -5.42%. Another way of stating this data is that EXG’s discount has expanded more than ETW’s. EXG has a current discount of -11.08% (1-year average: -6.24%) while ETW has a current discount of -6.70% (1-year average: -5.03%). This means that EXG is more attractive from a valuation standpoint compared to ETW. Note that world stocks (via the iShares MSCI ACWI (All Country World Index) Index ETF ( ACWI)) suffered a 3-month total return of -8.55%, meaning that both EXG and ETW outperformed their benchmark, as would be expected for option-income funds during stock market downturns. The 1-year premium/discount history of EXG is shown below (CEFConnect). We can see that its current discount is at its widest point for the past one year. (click to enlarge) The 1-year premium/discount history of ETW is shown below (CEFConnect). Based on the above analysis, a pairs trading strategy would entail selling ETW and buying EXG. Given that both funds have very similar 5-year average discount values (-9.45% for EXG and -8.90% for ETW), a reversion of EXG’s current discount of -11.08% and ETW’s current discount of -6.70% would allow investors to profit from the trade. Risks In my previous article, I wrote: More defensive funds (the ones with higher option coverages) are getting more expensive relative to the less defensive funds…What could one take away from this? One might infer that market participants are worried about an impending market correction, and are bidding up more defensive option income funds. It appears that the same phenomenon may be happening right now. As ETW has 100% option coverage, it is more defensive than EXG at 50% option coverage. Indeed, in 2011, ETW eked out a positive NAV total return performance of +0.98%, while EXG declined by -3.33%. By comparison, ACWI fell -7.60%. Thus, a risk of this pairs strategy is that if a market correction were to occur, ETW will likely fall less than EXG. Still, the high current discount of EXG does provide a margin of safety whatever happens. Top holdings The top holdings of EXG and ETW as of 7/31/2015 are shown below (source: CEFConnect). EXG Google Inc (NASDAQ: GOOG ) $109.01M 3.49% Ev Cash Reserves Fund 0.12 06 Aug 2015 $67.98M 2.18% Nike, Inc. B (NYSE: NKE ) $64.89M 2.08% Apple, Inc. (NASDAQ: AAPL ) $64.18M 2.06% Exxon Mobil Corporation (NYSE: XOM ) $58.57M 1.88% Home Depot, Inc. (NYSE: HD ) $56.87M 1.82% Roche Holding AG ( OTCQX:RHHBY ) $53.33M 1.71% Walt Disney Co (NYSE: DIS ) $52.62M 1.69% Prudential Financial (NYSE: PRU ) $51.89M 1.66% Medtronic, Inc. (NYSE: MDT ) $51.25M 1.64% Nippon Telegraph and Telephone Corp. (NYSE: NTT ) $50.25M 1.61% ETW Apple, Inc. $62.02M 4.61% Microsoft Corporation (NASDAQ: MSFT ) $36.47M 2.71% Amazon.com Inc (NASDAQ: AMZN ) $25.20M 1.87% Nestle SA ( OTCPK:NSRGY ) $24.41M 1.81% Novartis AG (NYSE: NVS ) $22.71M 1.69% Roche Holding AG $21.95M 1.63% Google Inc $20.61M 1.53% Gilead Sciences Inc (NASDAQ: GILD ) $20.32M 1.51% Fast Retailing Co., Ltd. ( OTCPK:FRCOY ) $19.59M 1.46% Google, Inc. Class A (NASDAQ: GOOGL ) $18.76M 1.39% Comcast Corp A (NASDAQ: CMCSA ) $17.91M 1.33% Summary I really like both EXG and ETW as option-income funds. Over both past 3-year and 5-year periods, both funds have achieved comparable total return performances with ACWI, but with lower volatility, resulting in higher Sharpe ratios compared to the benchmark ETF. Investors who own both EXG and ETW can consider further “juicing up” their portfolio returns by taking advantage of mean reversion in premium/discount values of the two CEFs. The current discount of -11.08% for EXG is more attractive than ETW’s at -6.70%, which suggests that investors could swap existing holdings of EXG for ETW. However, one risk of this strategy is that in a prolonged market correction, ETW will perform better than EXG, being the more defensive of the two funds. Scalper1 News
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