Tag Archives: closed

CEFL Still Attractive With 22.4% Yield And Large Component Discounts To Book Value

My projection of a $0.2659 monthly dividend for CEFL would result in a 22.4% yield on an annualized compounded basis. The weighted average discount to book value for the closed-end funds that comprise CEFL is a substantial 13.4%. The action by UBS to not issue any new notes of its outstanding ETRACS ETNs, which included CEFL, does not impair the credit or liquidity of CEFL. Fidelity, which a prohibited its clients from buying the old ETRACS ETNs such as CEFL has reversed that policy and has resumed allowing purchases of CEFL. The enormous discount to book value for many closed-end funds increased somewhat from last month. Last month, all 30 of the index components of the UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ), and the YieldShares High Income ETF (NYSEARCA: YYY ), which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, traded at discounts to book value. They are trading at even deeper discounts to book value now. From the inception of CEFL until three months ago, there were always some component closed-end funds trading at premiums to book value. Three months ago, two of the components were trading at premiums to book value. On a weighted average basis, the closed-end funds that comprise CEFL are trading at a 13.41% discount to book value as of November 20, 2015 as compared to 11.77% a month ago. The median discount for the 30 closed-end funds is 13.73% as compared to 12.41% a month ago. Thus, the case for CEFL based on the large discounts to book value is even more compelling. There has been some confusion regarding the decision by UBS AG (NYSE: UBS ) that it does not intend to issue any new notes in 38 of its outstanding ETRACS ETNs. These include CEFL. UBS stated in an October 8, 2015 press release : “…This announcement does not affect the terms of the outstanding Series A ETRACS ETNs identified below, including the right of noteholders to require UBS AG to redeem their notes on the terms, and at the redemption price……. In connection with the previously announced transfer by UBS AG to UBS Switzerland AG of specified assets, UBS Switzerland AG became a co-obligor of all outstanding debt securities designated as Series A, including the Series A ETRACS ETNs, issued by UBS AG prior to the transfer date…” This in no way impairs the rights or liquidity of CEFL and there are now two stated co-obligors for the ETNs, which if anything improves their credit. However, Fidelity for a while did not allow its customers to buy the Series A ETRACS ETNs. This caused some confusion and inconvenience for Fidelity customers and some frustration for Fidelity employees who realized this prohibition makes very little sense. However, Fidelity has changed its policy and now allows its customers to buy the Series A ETRACS ETNs. Closed-end funds typically trade at either discounts or premiums to book value. On balance, there is a slight bias towards discounts. Because of significant changes in the composition of the index, comparisons of aggregate discounts to book value from previous years are not very meaningful. That said, the 13.8% discount two months ago was the largest since the inception of CEFL. Seven months ago, CEFL had an 8.6% weighted discount to book value. Thus, in just six months, the discount had increased from 8.6% to 13.8%, and is still near the all-time record at the current 13.41% In attempting to find an explanation for the extreme discount to book values that the closed-end funds that comprise CEFL and YYY are trading at I considered two possible factors. One concern with many closed-end funds is that their dividends include a significant amount of return of capital. I ran regression analysis to determine if there was any correlation between the proportion of the dividend paid by a closed-end fund that represents a return of capital and the discount to book value that the closed-end fund is trading at. For the 30 closed-end funds that comprise the index CEFL is based on there was no statistically significant relationship. Another factor is the relatively high dividends paid by the closed-end funds. The 30 closed-end funds that comprise the index CEFL is based on have an average dividend yield based on the most recent dividend on an annualized but before compounding of 10.4%. These range from the highest GAMCO Global Gold Natural Resources & Income Trust (NYSEMKT: GGN ) with a yield of 16.67% to the lowest (still relatively high) yield of 8.33% of Invesco Dynamic Credit Opportunities Fund (NYSE: VTA ). A possible reason for the large discounts to book value might be that the relatively high dividend yields of the 30 closed-end funds cause investors to believe that these high yields are unsustainable or that high yields imply high risks. I ran regression analysis to determine if there was any correlation between the dividend yields and the discounts to book value that the closed-end fund are trading at. For the 30 closed-end funds that comprise the index CEFL is based on, there was no statistically significant relationship. Looking at the extremes in dividend yields with GGN yielding 16.67% and at a 12.35% discount to book value and VTA with an 8.33% yield and a 12.29% discount to book value also suggests no correlation between dividend yields and discounts to book value. For many securities other than closed-end funds, such as common stocks, discounts or premiums to book values are logically based on the business prospects for companies. Thus, Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) trades at significant premium to book value, while Peabody Energy (NYSE: BTU ) trades at a significant discount to book value, reflecting differing market perceptions of the future prospects for those companies. Google trades at approximately 5X book value while BTU trades at about one-fifth of book value. In my article: mREITs Impacted By Enormous Price To Book Swing – MORL Yielding 27.6%, I discussed the large discounts to book value that mREITs such as American Capital Agency Corp. (NASDAQ: AGNC ) are trading at. The logic behind mREITs such as AGNC trading at significant discounts to book value is primarily based on the possible impacts of higher future interest rates. Whether one agrees or disagrees with the magnitudes of the discounts or premiums to book for securities such as Google, Peabody and AGNC there are facts and logic related to each company’s business prospects that could possibly explain or justify changes in the premiums or discounts that have occurred in those stocks. There are no such facts or changes in market forecasts of business prospects that can possibly explain or justify changes in the premiums or discounts that have occurred in the closed-end funds that comprise CEFL. For closed-end funds, changes in the premiums or discounts to book value should be solely based on the value that investors place on the relative advantages and disadvantages of the closed-end fund structure, rather than the differing market perceptions of the future prospects for the securities in the closed-end funds’ portfolios. Investors in closed-end funds could purchase the securities held by a closed-end fund themselves. In most cases, there are also open-end funds available to investors that have risk, return and expense characteristics similar to any given closed-end fund. Changes in market perceptions of the prospects of the securities that comprise the portfolios of closed-end funds cannot logically explain or justify any change in the magnitudes of the discounts or premiums to book for the closed-end funds. Any such changes in market perceptions of the prospects of the securities in the portfolio should be reflected in the prices of the portfolio securities themselves. Thus, the ratio of the price of the closed-end fund to its book value should not be related to the expectations of the prospects for the portfolio securities held by the closed-end fund. If investors value the advantages of diversification, management and possibly lower transaction costs associated with owning a closed-end fund rather than owning the individual securities that comprise the closed-end fund’s portfolio more than the fees and expenses, which are the primary negative aspect of closed-end funds, then the closed-end fund will trade at a premium to book value. Conversely, if investors feel that the fees and expenses of the closed-end fund outweigh the advantages of diversification, management and possibly lower transaction cost associated with owning a closed-end fund, it will trade at a discount to book value. The trade-offs between the advantages and disadvantages associated with closed-end funds relative to the securities that comprise the portfolios of the closed-end funds are rational reasons for the closed-end funds to trade at discounts or premiums to book value. However, it is not rational for the discount or premium to be influenced by expectations of future returns on the securities that comprise the portfolios of the closed-end funds. If the market thinks that the securities in a closed-end fund’s portfolio will decline, and thus the net asset or book value of the closed-end fund will decline, there is no reason why the premium or discount that the closed-end fund is trading at should change. Some closed-end funds employ limited amounts of leverage. As investment companies, closed-end funds cannot have more than 33% leverage and most employ less, if any. That a closed-end fund does or does not employ a relatively small amount of leverage should not impact the premium or discount that the closed-end fund is trading at. Leverage is the easiest characteristic of a security to offset. Thus, if an investor was interested in a security but did not like the fact that the security employed 20% leverage, the investor could offset that leverage by combing that security with a risk-free asset. For example, if you had $10,000 to invest and you liked a closed-end fund but were unhappy with the 20% leverage, investing $8,000 in the closed-end fund and $2,000 in a risk-free asset will result in the same risk/return profile as investing $10,000 in the same closed-end fund, if that fund did not employ any leverage. Likewise, if you liked a closed-end fund but would rather that fund employed more leverage, you can buy that fund on margin and get in the same risk/return profile as investing in the fund if it had more leverage. Thus, leverage or lack of leverage should not influence the premium or discount that the closed-end fund is trading at since any leverage in a closed-end fund can be offset by an investor. There should be some limits as to how far away from book value a closed-end fund should trade. If a closed-end fund is trading at a sufficiently high premium to book value, an arbitrage opportunity could exist. Buying the securities in the closed-end fund’s portfolio and simultaneously selling the closed-end fund should generate a profitable arbitrage. Likewise if a closed-end fund is trading at a large enough discount, buying the closed-end fund and selling the securities that comprise the portfolio, it could generate arbitrage profits. These types of arbitrage would be risk arbitrage as opposed to riskless arbitrage. In riskless arbitrage, one buys a security or commodity and simultaneously sells something that is the equivalent of what you sold. An example of riskless arbitrage would be after a merger had been approved in which the acquirer is issuing one share of its stock for two shares of the company being acquired, you simultaneously buy two shares of the company being acquired for a total cost less than a share of the acquirer. This would essentially lock in a profit that would be realized when the merger closed and the values converged. Attempting to take advantage of the discount to book value being irrationally wide for a closed-end fund would be an example of risk arbitrage since there is no terminal event that will make the value of what you buy converge with what you sell. It may be irrational for a closed-end fund to trade at a 10% discount to book value. However, there is always the possibility that it could go to a 15% discount. As Keynes famously said, “The market can stay irrational longer than you can stay solvent.” Closed-end funds do not usually provide convenient opportunities for explicit risk arbitrage transactions where one security is bought and the other security is shorted. Retail investors usually cannot use the proceeds from selling some securities short to buy other securities. Hedge funds and institutions that may be able to use the proceeds from selling some securities short to buy others might find closed-end funds, and especially some of the securities that comprise the portfolios of the closed-end funds, not liquid enough to trade in. Even market participants who are able to use the proceeds from selling some securities short to buy others might be dissuaded from buying closed-end funds and shorting the securities in the closed-end funds’ portfolio, because of the fees and expenses charged by the closed-end funds. However, if the discount to book value is large enough, the fees and expenses charged by the closed-end funds could be offset by the discount to book value and thus generate a positive carry for a long closed-end fund — short the fund’s portfolio position. This would be especially true for closed-end funds that specialize in securities that generate higher income, such as those in the index upon which CEFL and its unleveraged counterpart YYY are based. An example of the discount to book value more than offsetting the fees and expenses would be a hypothetical closed-end fund whose portfolio securities yielded 10% before expenses. Most income-oriented closed-end funds have expense ratios lower than 1%. Shorting $100 worth of the securities that comprise the fund would require payments of $10 representing 10% annually to those who the securities were borrowed from. The $100 proceeds from the short sale could be used to acquire $100 of the closed-end fund. If the closed-end fund was trading at a 14% discount, $100 of the fund would represent 100/.86 = $116.28 worth of the securities in the fund. These securities yield 10%, so the gross income from the fund position would be $11.63. The net income, assuming a 1% expense ratio, would be $10.63. Thus, even after expenses and fees, an account long the closed-end fund would generate higher income than the portfolio securities while it waited for the discount to narrow to realize the risk arbitrage profit. While explicit risk arbitrage where the portfolio securities are shorted and the proceeds are employed to buy the closed-end fund might not occur in significant quantities to narrow the discount to book value, implicit arbitrage should eventually have an impact. Implicit risk arbitrage would occur as investors holding or wanting to hold securities with similar risk/return characteristics as a closed-end fund or the portfolios held by the closed-end fund shift from other securities to the closed-end fund. Institutional investors who had portfolios that contained securities similar to or identical to those held in a close-end fund could improve their risk/return profile by shifting out of securities in the closed-end fund to the closed-end fund, if the discount to book value for the closed-end fund was large enough. Retail investors could switch from securities held in portfolios of close-end fund to the closed-end fund and improve their risk/return profile if the discount to book value for the closed-end fund was large enough. More important, investors could shift out open-end mutual funds into closed-end mutual funds with similar objectives and portfolios. Open-end mutual funds are sold and redeemed at net asset value. Thus, there is never any discount or premium to book value for an open-end mutual fund. Advantages for investors in no-load mutual funds are that there are no transactions costs and the funds can always be redeemed at net asset or book value. Closed-end funds usually require some brokerage commission to buy and sell them, and there is risk that the closed-end fund will fluctuate due to changes in the premium or discount to net asset value in addition to fluctuation in the portfolio securities. The advantages of no-load open-end mutual funds are somewhat offset by the lower fees and expenses that closed-end funds usually have. When closed-end funds are trading at large discounts to book value, investors can significantly increase their returns by switching from open-end funds to closed-end funds that have similar assets but are selling at discounts to net asset value and typically have lower fees and expenses. When an investor redeems an open-end fund at net asset value, the open-end fund sells portfolio securities to fund the redemption. That would tend to lower the market prices of those portfolio securities. If the investor uses the proceeds from the redemption of the open-end fund to buy shares in a closed-end fund that holds similar portfolio securities, the net effect would be to put downward pressure on the market prices of the portfolio securities and upward pressure of the market prices of the closed-end funds. Thus, the discount to book value for the closed-end funds will tend to decline. This large discount to net asset value alone is still a good reason to be constructive on CEFL. It should be noted that saying CEFL components are now trading at a deeper discount to the net asset value of the closed-end funds that comprise the index does not mean that CEFL does not always trade at a level close to its own net asset value. Since CEFL is exchangeable at the holders’ option at indicative or net asset value, its market price will not deviate significantly from the net asset value. The net asset value or indicative value of CEFL is determined by the market prices of the closed-end funds that comprise the index upon which CEFL is based. My constructive view on CEFL stems not only from the wide discount to book value of the closed-end funds, but also from the very large dividends paid by CEFL. One troubling aspect of CEFL is the significant amount of the dividends paid by the closed-end funds that comprise CEFL that consists of return of capital. My calculation using available data indicates that 23.7% of the December CEFL dividend will consist of return of capital. However, there does not seem to be any statistically significant relationship between return of capital and the discounts to book value that the individual closed-end funds trade at. Of the 30 index components of CEFL, and YYY, which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, 29 now pay monthly. Only the Morgan Stanley Emerging Markets Domestic Debt Fund (NYSE: EDD ) now pays quarterly dividends in January, April, October, and July. Thus, EDD will not be included in the December 2015 CEFL monthly dividend calculation. My calculation projects an December 2015 dividend of $0.2659. While the 2014 year-end rebalancing has reduced the monthly CEFL dividend, it is still very large. For the three months ending December 2015, the total projected dividends are $0.8261. The annualized dividends would be $3.3044. This is a 20.4% simple annualized yield with CEFL priced at $16.20. On a monthly compounded basis, the effective annualized yield is 22.4%. Aside from the fact that with a yield above 20%, even without reinvesting or compounding, you get back your initial investment in only five years and still have your original investment shares intact. If someone thought that over the next five years markets and interest rates would remain relatively stable, and thus CEFL would continue to yield 22.4% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $274,919 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $22,400 initial annual rate to $61,629 annually. CEFL component weights and prices as of November 20, 2015 Name Ticker Weight Price NAV price/NAV ex-div dividend frequency contribution return of capital First Trust Intermediate Duration Prf.& Income Fd FPF 4.81 21.58 23.67 0.9117 11/2/2015 0.1625 m 0.0118 MFS Charter Income Trust MCR 4.54 8.05 9.22 0.8731 11/17/2015 0.06218 m 0.0114 0.0146 Eaton Vance Tax-Managed Global Diversified Equity Income Fund EXG 4.52 9.1 9.93 0.9164 11/19/2015 0.0813 m 0.0131 0.0696 Eaton Vance Limited Duration Income Fund EVV 4.45 12.75 14.78 0.8627 11/10/2015 0.1017 m 0.0115 Eaton Vance Tax-Managed Diversified Equity Income Fund ETY 4.41 11.29 12.04 0.9377 11/19/2015 0.0843 m 0.0107 Alpine Total Dynamic Dividend AOD 4.4 7.94 9.47 0.8384 11/18/2015 0.0575 m 0.0103 Clough Global Opportunities Fund GLO 4.36 10.95 12.82 0.8541 11/17/2015 0.1 m 0.0129 Blackrock Corporate High Yield Fund HYT 4.31 9.93 11.51 0.8627 11/12/2015 0.07 m 0.0099 0.0012 Alpine Global Premier Properties Fund AWP 4.3 5.89 7.1 0.8296 11/18/2015 0.05 m 0.0118 0.0300 Doubleline Income Solutions DSL 4.27 17.02 19.61 0.8679 11/10/2015 0.15 m 0.0122 Prudential Global Short Duration High Yield Fundd GHY 4.25 13.9 16.43 0.8460 11/18/2015 0.11 m 0.0109 Western Asset Emerging Markets Debt Fund ESD 4.22 13.99 16.85 0.8303 11/18/2015 0.105 m 0.0103 0.0112 PIMCO Dynamic Credit Income Fund PCI 4.21 18.23 21.5 0.8479 11/9/2015 0.16406 m 0.0123 ING Global Equity Dividend & Premium Opportunity Fund IGD 4.17 7.36 8.41 0.8751 11/2/2015 0.076 m 0.0140 0.0084 BlackRock International Growth and Income Trust BGY 3.89 6.29 7.07 0.8897 11/12/2015 0.049 m 0.0098 0.0466 GAMCO Global Gold Natural Resources & Income Trust GGN 3.69 5.04 5.75 0.8765 11/11/2015 0.07 m 0.0166 0.0700 Morgan Stanley Emerging Markets Domestic Debt Fund EDD 3.54 7.42 8.79 0.8441 9/28/2015 0.22 q Prudential Short Duration High Yield Fd ISD 3.36 14.48 16.79 0.8624 11/18/2015 0.11 m 0.0083 Aberdeen Aisa-Pacific Income Fund FAX 3.29 4.49 5.48 0.8193 11/19/2015 0.035 m 0.0083 0.0175 Calamos Global Dynamic Income Fund CHW 3.01 7.45 8.81 0.8456 11/6/2015 0.07 m 0.0092 0.0391 MFS Multimarket Income Trust MMT 2.97 5.69 6.63 0.8582 11/17/2015 0.04482 m 0.0076 0.0142 Backstone /GSO Strategic Credit Fund BGB 2.65 13.91 16.15 0.8613 11/18/2015 0.105 m 0.0065 0.0012 Western Asset High Income Fund II HIX 2.1 6.68 7.36 0.9076 11/18/2015 0.069 m 0.0070 0.0006 Blackrock Multi-Sector Income BIT 2.09 15.69 18.68 0.8399 11/12/2015 0.1167 m 0.0050 Allianzgi Convertible & Income Fund NCV 1.8 5.79 6.59 0.8786 11/9/2015 0.065 m 0.0066 Wells Fargo Advantage Multi Sector Income Fund ERC 1.71 11.4 13.68 0.8333 11/12/2015 0.0967 m 0.0047 0.0283 Wells Fargo Advantage Income Opportunities Fund EAD 1.33 7.5 8.64 0.8681 11/12/2015 0.068 m 0.0039 Nuveen Preferred Income Opportunities Fund JPC 1.28 9.17 10.28 0.8920 11/10/2015 0.067 m 0.0030 Allianzgi Convertible & Income Fund II NCZ 1.09 5.13 5.86 0.8754 11/9/2015 0.0575 m 0.0040 Invesco Dynamic Credit Opportunities Fund VTA 0.97 10.81 12.41 0.8711 11/12/2015 0.075 m 0.0022

CEFL’s Closed-End Funds’ Discounts To Book Value Defy Logic

The closed-end funds that comprise the index upon which CEFL is based are now trading at an average 13.8% discount to book value. This discount is beyond normal ranges and logically cannot be a function of market expectations. CEFL is projected to pay a monthly dividend of $0.3074, which brings the annualized monthly compounded yield to 23.7%. The high yield and discount to book value make a compelling case for CEFL. All 30 of the index components of the UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ), and the YieldShares High Income ETF (NYSEARCA: YYY ), which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, are now trading at discounts to book value. This is the first month since the inception of CEFL that this has been the case. Last month, two of the components were trading at premiums to book value. On a weighted average basis, the closed-end funds that comprise CEFL are trading at a 13.8% discount to book value as of September 18, 2015. The median discount for the 30 closed-end funds is 14.25%. Closed-end funds typically trade at either discounts or premiums to book value. On balance, there is a slight bias towards discounts. Because of significant changes in the composition of the index, comparisons of aggregate discounts to book value from previous years are not very meaningful. That said, the 13.8% discount is the largest since the inception of CEFL. The 13.8% weighted average discount to book value of the components that comprise the index is an increase in the discount that I computed last month of 13.1%. Five months ago, CEFL had an 8.6% weighted discount to book value. Thus, in just five months, the discount has increased from 8.6% to 13.8%. For many securities other than closed-end funds, such as common stocks, discounts or premiums to book values are logically based on the business prospects for companies. Thus, Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) trades at significant premium to book value while Peabody Energy (NYSE: BTU ) trades at a significant discount to book value, reflecting differing market perceptions of the future prospects for those companies. Google trades at approximately 5X book value while BTU trades at about 1/5 of book value. In my article: mREITs Impacted By Enormous Price To Book Swing – MORL Yielding 27.6% , I discussed the large discounts to book value that mREITs such as American Capital Agency Corp. (NASDAQ: AGNC ) are trading at. The logic behind mREITs such as AGNC trading at significant discounts to book value is primarily based on the possible impacts of higher future interest rates. Whether one agrees or disagrees with the magnitudes of the discounts or premiums to book for securities such as Google, Peabody and American Capital Agency, there are facts and logic related to each company’s business prospects that could possibly explain or justify changes in the premiums or discounts that have occurred in those stocks. There are no such facts or changes in market forecasts of business prospects that can possibly explain or justify changes in the premiums or discounts that have occurred in the closed-end funds that comprise CEFL. For closed-end funds, changes in the premiums or discounts to book value should be solely based on the value that investors place on the relative advantages and disadvantages of the closed-end fund structure, rather than the differing market perceptions of the future prospects for the securities in the closed-end funds’ portfolios. Investors in closed-end funds could purchase the securities held by a closed-end fund themselves. In most cases, there are also open-end funds available to investors that have risk, return and expense characteristics similar to any given closed-end fund. Changes in market perceptions of the prospects of the securities that comprise the portfolios of closed-end funds cannot logically explain or justify any change in the magnitudes of the discounts or premiums to book for the closed-end funds. Any such changes in market perceptions of the prospects of the securities in the portfolio should be reflected in the prices of the portfolio securities themselves. Thus, the ratio of the price of the closed-end fund to its book value should not be related to the expectations of the prospects for the portfolio securities held by the closed-end fund. If investors value the advantages of diversification, management and possibly lower transaction costs associated with owning a closed-end fund rather than owning the individual securities that comprise the closed-end fund’s portfolio more than the fees and expenses which are the primary negative aspect of closed-end funds, then the closed-end fund will trade at a premium to book value. Conversely, if investors feel that the fees and expenses of the closed-end fund outweigh the advantages of diversification, management and possibly lower transaction cost associated with owning a closed-end fund, it will trade at a discount to book value. The trade-offs between the advantages and disadvantages associated with closed-end funds relative to the securities that comprise the portfolios of the closed-end funds are rational reasons for the closed-end funds to trade at discounts or premiums to book value. However, it is not rational for the discount or premium to be influenced by expectations of future returns on the securities that comprise the portfolios of the closed-end funds. If the market thinks that the securities in a closed-end fund’s portfolio will decline, and thus the net asset or book value of the closed-end fund will decline, there is no reason why the premium or discount that the closed-end fund is trading at should change. Some closed-end funds employ limited amounts of leverage. As investment companies, closed-end funds cannot have more than 33% leverage and most employ less, if any. That a closed-end fund does or does not employ a relatively small amount of leverage should not impact the premium or discount that the closed-end fund is trading at. Leverage is the easiest characteristic of a security to offset. Thus, if an investor was interested in a security but did not like the fact that the security employed 20% leverage, the investor could offset that leverage by combing that security with a risk-free asset. For example, if you had $10,000 to invest and you liked a closed-end fund but were unhappy with the 20% leverage, investing $8,000 in the closed-end fund and $2,000 in a risk-free asset will result in the same risk/return profile as investing $10,000 in the same closed-end fund, if that fund did not employ any leverage. Likewise, if you liked a closed-end fund but would rather that fund employed more leverage, you can buy that fund on margin and get in the same risk/return profile as investing in the fund if it had more leverage. Thus, leverage or lack of leverage should not influence the premium or discount that the closed-end fund is trading at since any leverage in a closed-end fund can be offset by an investor. There should be some limits as to how far away from book value a closed-end fund should trade. If a closed-end fund is trading at a sufficiently high premium to book value, an arbitrage opportunity could exist. Buying the securities in the closed-end fund’s portfolio and simultaneously selling the closed-end fund should generate a profitable arbitrage. Likewise if a closed-end fund is trading at a large enough discount buying the closed-end fund and selling the securities that comprise the portfolio, it could generate arbitrage profits. These types of arbitrage would be risk arbitrage as opposed to riskless arbitrage. In riskless arbitrage, one buys a security or commodity and simultaneously sells something that is the equivalent of what you sold. An example of riskless arbitrage would be, after a merger had been approved in which the acquirer is issuing one share of its stock for two shares of the company being acquired, you simultaneously buy two shares of the company being acquired for a total cost less than a share of the acquirer. This would essentially lock in a profit that would be realized when the merger closed and the values converged. Attempting to take advantage of the discount to book value being irrationally wide for a closed-end fund would be an example of risk arbitrage since there is no terminal event which will make the value of what you buy converge with what you sell. It may be irrational for a closed-end fund to trade at a 10% discount to book value. However, there is always the possibility that it could go to a 15% discount as Keynes famously said “The market can stay irrational longer than you can stay solvent.” Closed-end funds do not usually provide convenient opportunities for explicit risk arbitrage transactions where one security is bought and the other security is shorted. Retail investors usually cannot use the proceeds from selling some securities short to buy other securities. Hedge funds and institutions which may be able to use the proceeds from selling some securities short to buy others might find closed-end funds, and especially some of the securities that comprise the portfolios of the closed-end funds, not liquid enough to trade in. Even, market participants who are able to use the proceeds from selling some securities short to buy others might be dissuaded from buying closed-end funds and shorting the securities in the closed-end funds’ portfolio, because of the fees and expenses charged by the closed-end funds. However, if the discount to book value is large enough, the fees and expenses charged by the closed-end funds could be offset by the discount to book value and thus generate a positive carry for a long closed-end fund – short the fund’s portfolio position. This would be especially true for closed-end funds that specialize in securities that generate higher income, such as those in the index upon which CEFL and its unleveraged counterpart YYY are based. An example of the discount to book value more than offsetting the fees and expenses would be a hypothetical closed-end fund whose portfolio securities yielded 10% before expenses. Most income-oriented closed-end funds have expense ratios lower than 1%. Shorting $100 worth of the securities that comprise the fund would require payments of $10 representing 10% annually to those who the securities were borrowed from. The $100 proceeds from the short sale could be used to acquire $100 of the closed-end fund. If the closed-end fund was trading at a 14% discount, $100 of the fund would represent 100/.86 = $116.28 worth of the securities in the fund. These securities yield 10%, so the gross income from the fund position would be $11.63. The net income, assuming a 1% expense ratio, would be $10.63. Thus, even after expenses and fees, an account long the closed-end fund would generate higher income than the portfolio securities while it waited for the discount to narrow to realize the risk arbitrage profit. While explicit risk arbitrage where the portfolio securities are shorted and the proceeds are employed to buy the closed-end fund might not occur in significant quantities to narrow the discount to book value, implicit arbitrage should eventually have an impact. Implicit risk arbitrage would occur as investors holding or wanting to hold securities with similar risk/return characteristics as a closed-end fund or the portfolios held by the closed-end fund shift from other securities to the closed-end fund. Institutional investors that had portfolios which contained securities similar to or identical to those held in a close-end fund could improve their risk/return profile by shifting out of securities in the closed-end fund to the closed-end fund, if the discount to book value for the closed-end fund was large enough. Retail investors could switch from securities held in portfolios of close-end fund to the closed-end fund and improve their risk/return profile if the discount to book value for the closed-end fund was large enough. More important, investors could shift out open-end mutual funds into closed-end mutual funds with similar objectives and portfolios. Open-end mutual funds are sold and redeemed at net asset value. Thus, there is never any discount or premium to book value for an open-end mutual fund. Advantages for investors in no-load mutual funds are that there are no transactions costs and the funds can always be redeemed at net asset or book value. Closed-end funds usually require some brokerage commission to buy and sell them, and there is risk that the closed-end fund will fluctuate due to changes in the premium or discount to net asset value in addition to fluctuation in the portfolio securities. The advantages of no-load open-end mutual funds are somewhat offset by the lower fees and expenses that closed-end funds usually have. When closed-end funds are trading at large discounts to book value, investors can significantly increase their returns by switching from open-end funds to closed-end funds that have similar assets but are selling at discounts to net asset value and typically have lower fees and expenses. When an investor redeems an open-end fund at net asset value, the open-end fund sells portfolio securities to fund the redemption. That would tend to lower the market prices of those portfolio securities. If the investor uses the proceeds from the redemption of the open-end fund to buy shares in a closed-end fund that holds similar portfolio securities, the net effect would be to put downward pressure on the market prices of the portfolio securities and upward pressure of the market prices of the closed-end funds. Thus, the discount to book value for the closed-end funds will tend to decline. This large discount to net asset value alone is a good reason to be constructive on CEFL. If the discount to book value for the closed-end funds that comprise CEFL were to revert from the current 13.8% to the 8.6% level of five months ago, CEFL would increase in price by 10.2% even if the prices of all of the component closed-end funds remained exactly the same. It should be noted that saying CEFL components are now trading at a deeper discount to the net asset value of the closed-end funds that comprise the index does not mean that CEFL does not always trade at a level close to its own net asset value. Since CEFL is exchangeable at the holders’ option at indicative or net asset value, its market price will not deviate significantly from the net asset value. The net asset value or indicative value of CEFL is determined by the market prices of the closed-end funds that comprise the index upon which CEFL is based. My constructive view on CEFL stems not only from the wide discount to book value of the closed-end funds, but also from the very large dividends paid by CEFL. Of the 30 index components of CEFL, and YYY which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, 29 now pay monthly. Only the Morgan Stanley Emerging Markets Domestic Debt Fund (NYSE: EDD ) now pays quarterly dividends in January, April, October, and July. Thus, EDD will be included in the October 2015 CEFL monthly dividend calculation. My calculation projects an October 2015 dividend of $0.3074. This is an increase of 4.6% from the September 2015 dividend of $0.2938 which did not include any contribution from EDD. A more relevant comparison is to the July 2015 which also included all 30 CEFL components. The projected October 2015 dividend of $0.3074 is a decline of 5.7% from the July 2015 CEFL dividend. The decline in the CEFL monthly dividend compared to July 2015 is primarily due to the reduction in the indicative or net asset value of CEFL. The indicative value of each CEFL share has decreased from $19.1358 on July 31, 2015, to $ 16.8889 on September 18, 2015. As I explained in MORL Dividend Drops Again In October, Now Yielding 21.5% On A Monthly Compounded Basis, if the dividends on all of the underlying components in a 2X leveraged ETN, such as CEFL, were to remain the same for a specific month, but the indicative value (aka net asset value or book value) was lower, the dividend paid, which is essentially a pass-through with no discretion by management, would also decrease. This is the result of the rebalancing of the portfolio each month required to bring the amount of leverage back to 2X. Of course, an increase in indicative value would result in a corresponding increase in the dividend. While the 2014 year-end rebalancing has reduced the monthly CEFL dividend, it is still very large. For the three months ending October 2015, the total projected dividends are $0.9031. The annualized dividends would be $3.61. This is a 21.4% simple annualized yield with CEFL priced at $16.85. On a monthly compounded basis, the effective annualized yield is 23.7%. Aside from the fact that with a yield above 20%, even without reinvesting or compounding, you get back your initial investment in only 5 years and still have your original investment shares intact. If someone thought that over the next five years markets and interest rates would remain relatively stable, and thus CEFL would continue to yield 23.7% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $289,350 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $23,700 initial annual rate to $68,576 annually. CEFL component weights as of August 28, 2015, prices as of September 18, 2015: Name Ticker Weight Price NAV price/NAV ex-div dividend frequency contribution return of capital First Trust Intermediate Duration Prf. & Income Fd (NYSE: FPF ) 4.81 21.96 23.53 0.9333 9/1/2015 0.1625 m 0.01202 DoubleLine Income Solutions (NYSE: DSL ) 4.54 18.41 20.49 0.8985 9/16/2015 0.15 m 0.01249 Eaton Vance Limited Duration Income Fund (NYSEMKT: EVV ) 4.47 13.03 15.28 0.8527 9/9/2015 0.1017 m 0.01178 MFS Charter Income Trust (NYSE: MCR ) 4.45 8.03 9.42 0.8524 9/15/2015 0.06378 m 0.01194 Eaton Vance Tax-Managed Global Diversified Equity Income Fund (NYSE: EXG ) 4.38 8.97 9.83 0.9125 9/21/2015 0.0813 m 0.01341 0.0676 BlackRock Corporate High Yield Fund (NYSE: HYT ) 4.37 10.26 12 0.8550 9/11/2015 0.07 m 0.01007 0.0012 Clough Global Opportunities Fund (NYSEMKT: GLO ) 4.33 11.07 13.49 0.8206 9/16/2015 0.1 m 0.01321 Alpine Total Dynamic Dividend (NYSE: AOD ) 4.32 7.93 9.56 0.8295 9/21/2015 0.0575 m 0.01058 PIMCO Dynamic Credit Income Fund (NYSE: PCI ) 4.29 18.88 21.98 0.8590 9/9/2015 0.164063 m 0.01259 Alpine Global Premier Properties Fund (NYSE: AWP ) 4.29 5.99 7.16 0.8366 9/21/2015 0.05 m 0.01210 Prudential Global Short Duration High Yield Fund (NYSE: GHY ) 4.24 14.11 16.7 0.8449 9/16/2015 0.11 m 0.01117 Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE: ETY ) 4.17 10.86 11.86 0.9157 9/21/2015 0.0843 m 0.01093 Western Asset Emerging Markets Debt Fund (NYSE: ESD ) 4.12 13.91 16.86 0.8250 9/16/2015 0.105 m 0.01050 0.0159 Voya Global Equity Dividend & Premium Opportunity Fund (NYSE: IGD ) 4.05 7.27 8.48 0.8573 9/1/2015 0.076 m 0.01430 0.0266 BlackRock International Growth & Income Trust (NYSE: BGY ) 3.83 6.29 7.2 0.8736 9/11/2015 0.049 m 0.01008 0.0490 GAMCO Global Gold Natural Resources & Income Trust (NYSEMKT: GGN ) 3.77 5.24 5.86 0.8942 9/14/2015 0.07 m 0.01701 0.0700 Morgan Stanley Emerging Markets Domestic Debt Fund (EDD) 3.52 7.51 8.99 0.8354 9/26/2015 0.22 q 0.03483 Prudential Short Duration High Yield Fd (NYSE: ISD ) 3.37 14.75 17.17 0.8591 9/16/2015 0.11 m 0.00849 Aberdeen Asia-Pacific Income Fund (NYSEMKT: FAX ) 3.26 4.53 5.47 0.8282 9/16/2015 0.035 m 0.00851 0.0143 MFS Multimarket Income Trust (NYSE: MMT ) 3.02 5.88 6.78 0.8673 9/15/2015 0.04588 m 0.00796 0.0168 Calamos Global Dynamic Income Fund (NASDAQ: CHW ) 2.95 7.42 8.86 0.8375 9/8/2015 0.07 m 0.00940 Backstone/GSO Strategic Credit Fund (NYSE: BGB ) 2.8 14.95 17.43 0.8577 9/21/2015 0.105 m 0.00664 0.0012 BlackRock Multi-Sector Income (NYSE: BIT ) 2.1 16.03 19.01 0.8432 9/11/2015 0.1167 m 0.00516 Western Asset High Income Fund II (NYSE: HIX ) 2.08 6.73 7.72 0.8718 9/16/2015 0.069 m 0.00720 0.0006 AGIC Convertible & Income Fund (NYSE: NCV ) 1.95 6.37 7.21 0.8835 9/9/2015 0.065 m 0.00672 Wells Fargo Advantage Multi-Sector Income Fund (NYSEMKT: ERC ) 1.73 11.76 14.15 0.8311 9/11/2015 0.0967 m 0.00481 0.0283 Wells Fargo Advantage Income Opportunities Fund (NYSEMKT: EAD ) 1.35 7.56 9.04 0.8363 9/11/2015 0.068 m 0.00410 Nuveen Preferred Income Opportunities Fund (NYSE: JPC ) 1.26 9.19 10.23 0.8983 9/11/2015 0.067 m 0.00310 AGIC Convertible & Income Fund II (NYSE: NCZ ) 1.19 5.67 6.42 0.8832 9/9/2015 0.0575 m 0.00408 Invesco Dynamic Credit Opportunities Fund (NYSE: VTA ) 0.97 11 12.79 0.8600 9/10/2015 0.075 m 0.00223

Franklin Universal Trust: An Interesting Mix In This CEF

Summary FT’s goal is current income and capital preservation. FT takes a unique approach to that, mixing risky assets with more stable ones. It’s not a fund I’d rush to own, but it could have a place with the right investor. Franklin Universal Trust (NYSE: FT ) is an odd beast in some ways and yet logically built in other ways. At the end of the day, however, if you are buying it as a long-term investor you need to understand that it’s playing in two allocation sectors and that may not fit well within your broader portfolio. What it does Franklin Universal Trust’s primary objective is income and preservation of capital. Its secondary objective is growth of income. That said, it has a funny way of going about reaching these three goals since it invests in a combination of high-yield bonds and utility stocks. The split is around two-thirds bonds and one-third utilities. There are some other things in the mix, like preferred shares and resource stocks, but they are relatively minor positions. FT also makes use of leverage to enhance performance. According to the Closed-End Fund Association , leverage recently stood at around 23% of assets. Essentially, FT is mixing a relatively conservative investment category, utilities, with a riskier one, junk bonds. That’s not an outlandish proposition at all, but it makes this fund something of a difficult fit if you have your own portfolio allocation goals. For example, you’ll need to go down another level, looking at the fund’s portfolio allocations, to truly ensure your portfolio weightings are what you want them to be if you own FT. That wouldn’t be needed for pure-play offerings. There’s not much information available about what the fund actually does to pick its stocks and bonds, except that it uses fundamental research on the bond side and looks for attractive dividend yields and a history of dividend increases in the utility space. That’s not much to work with if you want to really understand what your managers are doing. In fact, it’s utility portfolio is comprised of some of the largest and best-known utilities in the country, a portfolio which you could arguably create yourself if you wanted to. How’s it done? Because of the odd mix of assets, it’s kind of hard to benchmark this fund. That said, it’s 10-year trailing annualized return through January comes in at about 8.5% according to Morningstar (this figure includes dividend reinvestment). That ranks in the top percentile of Morningstar’s “Tactical Allocation” category, but I’m not sure that’s exactly the right place to put this fund-though, to be fair, I have no better suggestion as to where it belongs. For comparison, Vanguard 500 Index Fund (MUTF: VFINX ) turned in a trailing 10 year return of just under 8% annualized. It’s standard deviation over the trailing ten year period was around 13. That’s not much lower than the S&P 500 Index, so FT isn’t exactly a low volatility offering. To bring that point home even more keenly, the standard deviation of Vanguard High-Yield Corporate Fund (MUTF: VWEHX ) over that span was around 9 and Vanguard Utilities Index Fund’s (MUTF: VUIAX ) was about 13. These two funds produced annualized returns of around 6.5% and 9.5%, respectively, over the trailing ten years. So in some ways FT is getting a higher return than you might achieve in other investments, including pure play high-yield funds and an S&P 500 Index fund, but it’s taking on more risk to do it-though not quite as much as an S&P 500 Index fund. And it’s worth noting that the fund’s net asset value, or NAV, fell nearly 37% in 2008. It’s share price fell nearly 41%. Clearly that was a disastrous year for investing, but it’s a real-world reminder that mixing high-yield with utilities isn’t going to save you from market volatility. To be fair, the NAV rose nearly 55% in 2009 (the share price advanced 70%), so what went down hard came back with a vengeance. You just have to be prepared for that kind of price movement should the market get volatile again. And, overall, don’t expect the fund to be a low risk offering. It isn’t. The fund’s distribution, meanwhile, has been fairly steady year in and year out. The current yield is around 6.6%. That’s nothing to write home about but it is an achievable distribution that has allowed for the NAV to increase from $5.85 a share in August of 2010 to a recent figure of around $8.15. And all of its distributions of late have been funded with dividend income, interest, and capital gains. So, as far as it goes, it appears to have lived up to its income objective, though not so much the income growth goal. Expenses are a tad high, but that’s largely related to the fund’s use of leverage. In fact, according to the Closed-End Fund Association, the management fee is less than 1% of assets, which is pretty reasonable. However, total expenses come in at close to 2% and have been as high as 2.6% in recent years. The cost of leverage adds a lot to this relatively small fund’s expenses. You gotta know what you own At the end of the day, FT is an unusual combination of investments, similar in some ways to Cohen & Steers REIT and Preferred Income Fund (NYSE: RNP ) another closed-end fund I’ve reviewed that invests in both real estate investment trusts and preferred shares. If you are trying to build a portfolio based on an asset allocation model, FT and RNP probably aren’t the right fund for you. You’ll have to dig into their portfolios to make sure you don’t over- or under-weight key asset classes. You’d likely be better off just buying pure play funds to keep your life simple That said, if you are looking for a decent fund with a solid yield, RF isn’t a bad option. It’s done reasonably well over time, though not spectacularly, while paying a consistent distribution. That’s hard to argue with, as long as you understand that you’re buying an odd hybrid fund. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.