Equity CEFs: A No Brainer In The Nuveen Dow 30 Dynamic Overwrite Fund
Summary The Dow Jones Industrial Average has been the worst performer of the three major US indices so far in 2015, down -5.8% through September 16th. However, a rebound in the global markets could help the DJIA the most since the index represents 30 of the largest multi-national blue chip companies in the US. One CEF that correlates with the DJIA has seen its market price also suffer even as its NAV outperforms the DJIA. This has created a no-brainer opportunity in my opinion. Four months ago I wrote this article, How To Buy The DJIA At A 10% Discount And A 6.9% Yield . Well, guess what? Now you can own that same fund, the Nuveen Dow 30 Dynamic Overwrite fund (NYSE: DIAX ) , $13.66 market price, $15.45 NAV, -11.6% discount, 7.8% current market yield, at an even bigger discount and yield. And if four months from now the fund is at a -13% discount and an even higher yield, I would tell you to buy more. But to me this already is a no brainer. Why? Because I believe institutional investors have got to take notice when an arbitrage opportunity this obvious presents itself. When you know you’re dealing with a pretty straightforward fund like DIAX, which only owns 30 large cap stocks and sells options against 50% of its positions, you can take a fairly large position even with limited liquidity if you know you can hedge the downside in more liquid ETFs. And when the spread is this large and involves index funds, I believe this becomes too juicy to ignore. Note: DIAX also owns a couple popular index ETFs, DIA and SPY , in which options are used as well. Index-based CEFs are the easiest funds to understand and more importantly the easiest to hedge if you want to have an arbitrage position. For this reason and the fact that index CEFs are so predictable in their NAV moves, their market prices usually don’t stray too far from their NAVs. But that hasn’t been the case with DIAX or really any of the four new Nuveen option income CEFs this year. Note: For some background on the four Nuveen option income CEFs, please read the above article link. All of the new Nuveen option income CEFs are index based and they all got started in late December 2014. Three out of the four new funds were the result of mergers between previous option income CEFs from Nuveen. However, DIAX has suffered the worst as it’s the only one tied to the DJIA as its benchmark. So a poor performing Dow Jones Industrial Average this year has just been amplified in a less liquid CEF that correlates to it. This is shown in the following Premium/Discount graph in which DIAX’s discount has continued to widen. So despite a defensive option strategy, DIAX has seen a continued valuation drop in its market price and the reasons for the widening discount I believe are two fold. One is because DIAX was the result of the merger between two old Nuveen option CEFs correlated to the DJIA and if you owned both funds (DPO) and (DPD) prior to the merger, which a lot of investors did including myself, you probably didn’t want to own all of the shares of the new fund simply because that would have given you a much larger exposure in just one fund. This, I believe, resulted in the initial steep drop in valuation shown. The second reason is that DIAX’s market price has fallen pretty substantially since the beginning of the year due to weakness in the Dow Jones Industrial Average, the increased market price discount of DIAX and then also because of the quarterly distributions which totals $0.80/share so far this year. So from a pure depreciation basis, i.e. not including distributions, DIAX’s market price has dropped from $16.38 when it started trading in late December to $13.66 today. As a result, I believe tax-loss selling has now further exacerbated DIAX’s discount as investors lock in a loss with perhaps the expectation that the Dow Jones Industrial Average might be even lower in mid October or later in the year when they could buy the fund back. This is all speculation of course but I can’t think of any other reason why anyone would be so shortsighted to sell DIAX now at a -11.6% discount, particularly when the DJIA is starting to look firmer as some of its weakest components, i.e. Exxon Mobil Corp (NYSE: XOM ) and Chevron (NYSE: CVX ) , show some life. But there’s another reason why this doesn’t make any sense. As an option income CEF, DIAX’s NAV will hold up better than the DJIA in a weak market environment. This is part of DIAX’s strategy to reduce volatility while paying an enhanced yield, something you generally don’t get with ETFs. In other words, the weaker the DJIA stays, the better DIAX looks even if it’s not showing up in the market price for the above mentioned reasons. This is reflected in DIAX’s NAV performance so far this year which is off only -3.5% on a total return basis compared to the DJIA being off -5.8%. That may not sound like a big percentage difference but in the eyes of an institutional investor who might take a larger position in DIAX if they knew they could arbitrage the position with a more liquid ETF that performance difference is compelling in a down market. But then there’s also just the common sense factor. Who would sell a fund that owns nothing but the 30 bluest chip companies in America at $13.66 when its liquidation value is a bona fide $15.45 per share currently? Unlike a fixed-income or leveraged CEF in which you can’t entirely be sure that the NAV would represent the liquidation value (certainly a lot closer than book value however), a $500 million CEF that only owns 30 heavily traded positions could be liquidated in a day at pretty close to its NAV. Now some people could argue that what good is the discount if you never get to realize the step up value? That is true, the liquidation of a CEF is a rare event that you certainly shouldn’t count on. But that’s not the reason you invest in heavily discounted CEFs even though it would be reason enough in a worst case scenario. No, the biggest reason why you invest in heavily discounted CEFs is simply because you receive a larger yield than what the fund is responsible for paying. In other words, the NAV yield of a CEF is what it has to cover. But funds at discounted market prices means you receive a higher yield than what the fund is paying. So in a case like DIAX, its NAV yield is a very reasonable 6.9% but its current market price yield is 7.8% because of the discount. Again, maybe not such a big deal to an individual investor but to an institutional investor, that’s a big difference if you have a large position. Conclusion So what could go wrong? Well, certainly if the global economy takes another leg down that’s probably not going to help the US multi-national companies that dominate the DJIA. And though DIAX’s NAV would continue to outperform the Dow Jones Industrial Average in such a scenario, investors could still drive down DIAX’s market price based on emotional selling and a lack of buyers. This has been happening a lot to CEFs over the summer, i.e. not heavy selling but just a lack of buyers. Nonetheless, I believe this is one of the more compelling opportunities I’ve seen in a while, especially if the Dow Jones Industrial Average component stocks start to perform better since you know DIAX’s NAV will perform close to that of the index, holding up better during flat to moderately down periods and lagging a bit during up periods. But you won’t get any surprises with DIAX and you can lock in a nice windfall yield to boot. On a market price basis, I suppose tax-loss selling could continue and that might keep a lid on the market price for awhile no matter what the DJIA index does but I’ve also got to believe that institutional investors would step up and take advantage of an arbitrage opportunity at these levels. An -11.6% discount to the Dow Jones Industrial Average is huge, comparatively like going back to 2013 when the DJIA was below 15,000. It also gives institutional investors an opportunity to play both sides in a more volatile market environment in which both arbitrage positions will probably be profitable at one time or another. For individual investors, I would not recommend an arbitrage and I believe the current discount and yield is opportunity enough. But if you did want to hedge a position, you could either short the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) (though you would be responsible for paying a monthly dividend) or you could buy an inverse fund like the ProShares Short Dow 30 fund (NYSEARCA: DOG ) which is a 1X the inverse of the DJIA. Disclosure: I am/we are long DIAX, DIA. (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.