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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 Still Attractive With 21.9%Yield

My projection of a $0.2758 monthly dividend for CEFL would result in a 21.9% yield on an annualized compounded basis. The weighted average discount to book value for the closed-end funds that comprise CEFL is less than it has been recently, but it is still substantial. 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. The enormous discount to book value than many of the closed-end funds has lessened somewhat. 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 still trading at discounts to book value now. From the inception of CEFL until two months ago, there were always some component closed-end funds trading at premiums to book value. Two months ago, two of the components were trading at premiums to book value. The discount to book value is not as large as it was a month ago. On a weighted average basis, the closed-end funds that comprise CEFL are trading at a 11.77% discount to book value as of October 23, 2015 as compared to 13.8% a month ago. The median discount for the 30 closed-end funds is 12.41% as compared to 14.25% a month ago. Thus, the case for CEFL based on the large discount to book value still exists, but is less compelling than it was previously. 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 now does not allow its customers to buy the Series A ETRACS ETNs. This has caused some confusion and inconvenience for Fidelity customers and some frustration for Fidelity employees who realize this prohibition makes very little sense. However, as far as I know, no other brokerage firm has prohibited its customers from buying the UBS 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 last month was the largest since the inception of CEFL. Six months ago, CEFL had an 8.6% weighted discount to book value. Thus, in just five months, the discount had increased from 8.6% to 13.8%, but has since come down to 11.77% 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. Although with the discount receding, the case is not as compelling as previously. 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 18.5% of the November CEFL dividend will consist of return of capital. Another caveat is that, as is shown in the table below, some of the closed-end funds have not officially declared their monthly dividends with ex-dates in October 2015. All of those have declared the same monthly dividend for at least the last five months. I have assumed they will declare the same dividend in October as they did in the last five months. 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 November 2015 CEFL monthly dividend calculation. My calculation projects an November 2015 dividend of $0.2758. This is an decrease of 6.1% from the September 2015 dividend of $0.2938, which also did not include any contribution from EDD. While the 2014 year-end rebalancing has reduced the monthly CEFL dividend, it is still very large. For the three months ending November 2015, the total projected dividends are $0.8733. The annualized dividends would be $3.4932. This is a 20.0% simple annualized yield with CEFL priced at $17.49. On a monthly compounded basis, the effective annualized yield is 21.9%. 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 21.9% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $269,233 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $21,900 initial annual rate to $58,962 annually. CEFL component weights as of as of September 30, 2015, prices as of October 23, 2015 Name Ticker Weight Price NAV price/NAV ex-div dividend frequency contribution return of capital First Trust Intermediate Duration Prf.& Income Fd FPF 4.91 21.72 23.56 0.9219 10/01/2015 0.1625 q 0.0128 Eaton Vance Limited Duration Income Fund EVV 4.55 13.15 15.11 0.8703 10/8/2015 0.1017 m 0.0123 MFS Charter Income Trust MCR 4.49 8.2 9.36 0.8761 10/13/2015 0.06276 m 0.0120 0.0628 Doubleline Income Solutions DSL 4.45 17.9 20.04 0.8932 10/14/2015 0.15 m 0.0130 Blackrock Corporate High Yield Fund HYT 4.4 10.37 11.82 0.8773 10/13/2015 0.07 m 0.0104 0.0012 Clough Global Opportunities Fund GLO 4.38 11.31 13.02 0.8687 10/14/2015 0.1 m 0.0135 PIMCO Dynamic Credit Income Fund PCI 4.34 18.9 21.8 0.8670 10/7/2015 0.164063 m 0.0132 Prudential Global Short Duration High Yield Fundd GHY 4.33 14.53 16.59 0.8758 10/14/2015 0.11 m 0.0115 Alpine Total Dynamic Dividend AOD 4.27 8.04 9.47 0.8490 9/21/2015 0.0575 m 0.0107 Eaton Vance Tax-Managed Global Diversified Equity Income Fund EXG 4.23 9.15 9.97 0.9178 10/21/2015 0.0813 m 0.0131 0.0659 Alpine Global Premier Properties Fund AWP 4.18 6.22 7.32 0.8497 9/21/2015 0.05 m 0.0118 Western Asset Emerging Markets Debt Fund ESD 4.13 14.37 17.06 0.8423 10/21/2015 0.105 m 0.0106 0.0146 Eaton Vance Tax-Managed Diversified Equity Income Fund ETY 4.13 11.3 12.04 0.9385 10/21/2015 0.0843 m 0.0108 ING Global Equity Dividend & Premium Opportunity Fund IGD 4.04 7.69 8.6 0.8942 10/1/2015 0.076 m 0.0140 0.0266 BlackRock International Growth and Income Trust BGY 3.86 6.55 7.17 0.9135 10/13/2015 0.049 m 0.0101 0.0417 GAMCO Global Gold Natural Resources & Income Trust GGN 3.75 5.84 6.21 0.9404 10/14/2015 0.07 m 0.0157 Prudential Short Duration High Yield Fd ISD 3.5 14.87 17.01 0.8742 10/14/2015 0.11 m 0.0091 Aberdeen Aisa-Pacific Income Fund FAX 3.39 4.74 5.59 0.8479 10/19/2015 0.035 m 0.0088 0.0147 Morgan Stanley Emerging Markets Domestic Debt Fund EDD 3.37 7.57 9.04 0.8374 9/28/2015 0.22 q MFS Multimarket Income Trust MMT 3 5.88 6.75 0.8711 10/13/2015 0.04517 m 0.0081 0.0452 Calamos Global Dynamic Income Fund CHW 2.89 7.71 8.76 0.8801 10/7/2015 0.07 m 0.0092 Backstone /GSO Strategic Credit Fund BGB 2.78 14.38 16.76 0.8580 9/21/2015 0.105 m 0.0071 0.0012 Blackrock Multi-Sector Income BIT 2.15 16.34 18.95 0.8623 10/13/2015 0.1167 m 0.0054 Western Asset High Income Fund II HIX 2.09 6.86 7.59 0.9038 10/21/2015 0.069 m 0.0074 0.0006 Allianzgi Convertible & Income Fund NCV 1.86 6.38 6.96 0.9167 10/8/2015 0.065 m 0.0066 Wells Fargo Advantage Multi Sector Income Fund ERC 1.75 12.03 14.07 0.8550 9/11/2015 0.0967 m 0.0049 0.0283 Wells Fargo Advantage Income Opportunities Fund EAD 1.38 7.86 8.91 0.8822 9/11/2015 0.068 m 0.0042 Nuveen Preferred Income Opportunities Fund JPC 1.29 9.28 10.26 0.9045 10/13/2015 0.067 m 0.0033 Allianzgi Convertible & Income Fund II NCZ 1.15 5.69 6.2 0.9177 10/8/2015 0.0575 m 0.0041 Invesco Dynamic Credit Opportunities Fund VTA 0.98 10.87 12.55 0.8661 10/13/2015 0.075 m 0.0024

Closed-End Fund IPO Review For 2014 And 2015

Reviews market price and NAV performance for closed-end fund IPOs in 2014 and 2105. Average market performance lagged NAV performance, but their were a few exceptions. Issuers are now offering incentives to encourage investors to buy closed-end fund IPOs. In the past, I have published several performance analyses of closed-end fund IPOs. Quite often, these IPOs provide a buying opportunity as they approach their one year anniversary. The reasons for this are: 1) Closed-end fund IPOs have generally been marketed at a 5% premium over NAV reflecting the sales commission and underwriting expenses. By the time the one year anniversary is reached, underwriters no longer support the price, and the funds often trade at a discount to NAV. 2) Closed-end funds are usually marketed when their underlying asset class is “hot” and in demand. Quite often these asset classes have cooled off a year later which leads to lower prices. 3) When a closed-end fund approaches its one year anniversary, it is quite common the case that most of the shareholder base holds it with an unrealized short term capital loss. There is a strong incentive to sell the fund before one year is up. After one year, it would turn into a long term capital loss which is less valuable for tax purposes. In 2015, there have only been three new closed-end fund IPOs. In many ways, closed-end funds are becoming an endangered species with many of them disappearing in the last year from fund mergers and fund liquidations. Because of this, I also included the 2014 closed-end fund IPOs in this article. Ticker Inception NAV Current NAV NAV Gain Inception Market Price Current Market Price MKT Gain Inception (NYSE: FPL ) 19.06 15.23 -20.1% 20 14.20 -29.0% Mar. 2014 (NYSE: JMLP ) 19.06 11.32 -40.6% 20 12.20 -39.0% Mar. 2014 (NYSE: DSE ) 19.06 9.90 -48.1% 20 10.20 -49.0% June 2014 (NYSE: THQ ) 19.06 20.03 +5.1% 20 18.22 -8.9% July 2014 (NYSE: GER ) 19.06 9.38 -50.8% 20 10.53 -47.4% Sep. 2014 (NYSE: ECC ) 19.93 18.65 -6.4% 20 20.21 +1.0% Oct. 2014 ( BST 19.06 18.33 -3.8% 20 16.62 -16.9% Oct. 2014 (NYSE: HIE ) 19.06 14.79 -22.4% 20 13.72 -31.4% Nov. 2014 (NASDAQ: CCD ) 23.83 21.91 -8.1% 25 19.31 -22.8% Mar. 2015 (NYSE: ACV ) 23.83 21.39 -10.2% 25 18.48 -26.1% May 2015 (JHY) 9.85 9.59 -2.6% 10 10.24 +2.4% July 2015 * NAV values are as of 9/04/2015 except for ECC. The NAV for ECC is as of 7/31/2015. Average NAV gain= -18.9% Average Mkt gain = -24.3% Market Price under performance= 5.4% Just like in previous years, the average market performance for the new IPO funds was worse than the average NAV performance. This generally occurs because the NAV premiums from underwriting fees are replaced by discounts below NAV within six months. Note that for a few of the new IPOs, the closed-end fund wrapper did outperform the NAV. For example, JMLP lost 39% (before dividends). But the NAV value of JMLP lost 40.6%. Something similar happened with GER, where the market price lost 47.4%, but the NAV dropped even more- a whopping 50.8%. Both of these funds are currently trading at a premium over NAV, probably because some investors who own them in taxable accounts may see some value in the large unrealized capital losses that are currently sitting in both funds. A research paper ” A Liquidity-Based Theory of Closed-End Funds ” tries to develop a rational liquidity-based model to explain why investors are willing to buy a closed-end fund at a premium at the IPO price when they know that it will soon fall to a discount. They reason that many closed-end funds hold illiquid, hard-to-trade underlying assets. Retail investors would find it very difficult to trade these assets directly, so they are willing to pay a premium to avoid the large illiquidity costs, especially if there are no equivalent no-load funds available for those assets. But more and more closed-end investors have learned that it usually pays to wait for six months before buying closed-end fund IPOs. In order to market new funds, some of the management companies are now offering special incentives like term limits or share buyback programs. For example, CCD has offered a term limit that allows shareholders to vote on a share liquidation after 15 years. Calamos, the fund manager, has committed to purchase up to $20 million in CCD common shares in the secondary market whenever the discount exceeds 2%. Starting in late July, they have been purchasing about 6,000 shares a day, but they have been unable to reduce the discount by much and it is currently -11.9%. ACV, recently issued by Allianz, has offered similar features with a 15-year limited term structure and a share buyback program of up to $125,000 a day for around 6 months, when the discount exceeds 2%. The buyback program for ACV should begin this week, and it will be interesting to see how much they can narrow the discount which is currently -13.6%. JHY offers a shorter term limit of only five years and marketed the fund for only $10 when the original NAV was $9.85. JHY is still pretty new, but so far it has retained its premium over NAV. It will be interesting to watch this one going forward. It looks like the closed-end fund industry may be waking up to the new reality and will be offering IPO investors somewhat better deals in the future. Later this year, there should be plenty of good opportunities in closed-end funds because of tax loss selling, not only in busted IPOs. Almost all of the MLP and commodity closed-end funds are greatly depressed, and there also many bargains in fixed income closed-end funds where discounts have widened out. Disclosure: I am/we are long CCD. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.