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2 Weeks Later: Did Mean Reversion Of CEFs Take Place?

Summary Annual rebalancing in YYY/CEFL led to systematic inflation and suppression of CEF prices. A previous article suggested to sell the CEFs that were added to the index and to buy the CEFs that were removed, after the rebalancing date. Two weeks later, some evidence of mean reversion is observed, though most of these effects were not statistically significant. Introduction In a previous series of articles, we explored interesting events that happened to the YieldShares High Income ETF (NYSEARCA: YYY ), a CEF “fund-of-funds,” and the ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ), the 2X leveraged version of YYY, at the end of the year. Both funds are based on the ISE High Income Index [YLDA], which rebalances annually on the last trading day of each year. After ISE gave notice of the proposed changes that it planned to make to the index on 12/24/2014, we observed high-volume buying of CEFs that were to be added to YYY/CEFL, and high-volume selling of the CEFs that were to be removed. The latter acted to depress the prices of existing constituents in the fund, causing YYY to significantly underperform the PowerShares CEF Income Composite Portfolio ETF (NYSEARCA: PCEF ), a CEF fund-of-funds that tracks a different index. Moreover, we observed price “spikes” for the underlying CEFs at the close of 12/31/2014, suggesting that YYY/CEFL were forced to rebalance at unfavorable prices. On the next day, 1/2/2015, YYY fell 1.25% (and CEFL fell 2.96%) on a day where stocks, bonds and PCEF held relatively flat. YYY Total Return Price data by YCharts The second of the articles suggested a third possible way in which YYY/CEFL investors could lose money: reversion of premium/discount values of the CEFs that had been added to the index. The heavy buying of these CEFs had pushed the premium/discount values of those funds to higher (i.e. more expensive) levels, leaving investors in those funds susceptible to reversion in premium/discount values. Thus, the article suggested to sell the CEFs that were added to the index and to buy the CEFs that were removed from the index to take advantage of mean reversion. This article provides an update on whether that hypothesis played out. Results and discussion The second of the articles was published on 1/6/2015, as it took me a few days to piece together the events surrounding the rebalancing event. Nevertheless, I will be using 1/2/2015 as the starting point for the performance comparisons as this is the day after the rebalancing took place. CEFs that were added We first consider the 10 CEFs that had the highest increases in allocation upon YYY rebalancing. Those 10 CEFs had increases ranging from 3.52% for ISD to 4.59% for DSL. The following graph shows the total return performance for those 10 CEFs from 1/2/2015 to 1/16/2015 (just over two weeks). EDD Total Return Price data by YCharts Those 10 CEFs had an average performance of -1.26%. The following table shows the premium/discount values for those 10 CEFs two weeks ago (1/5/2015) and today. CEFs are arranged in order of increasing premium/discount on 1/5/2015. Two weeks ago Today Change EDD -10.51 -10.42 0.09 GLO -10.2 -11.39 -1.19 PCI -9.43 -9.64 -0.21 HYT -9.22 -9.02 0.20 MCR -8.47 -11.98 -3.51 DSL -7.9 -8.06 -0.16 GHY -7.51 -5.13 2.38 ISD -7.11 -6.88 0.23 AWP -7.04 -11.52 -4.48 FPF -6.68 -7.85 -1.17 Average -8.41 -9.19 -0.78 We can see that premium/discount value of these 10 CEFs decreased by an average of -0.78%. The following chart displays the change in premium/discount values graphically, with CEFs arranged from the largest change to the smallest. We can see that 4 of the CEFs saw an increase in premium/discount value, while 6 of the CEFs saw a decrease in premium/discount value. Notably, the four funds that had the greatest decrease in premium/discount values (FPF, GLO, MCR and AWP) were the exact same funds that had the greatest positive deviation from 1-year historical premium/discount value two weeks ago (the largest white bars in this chart linked from my previous article). Overall, these data appear to support the hypothesis that the CEFs that were added to the index saw an inflation of value before rebalancing, making them susceptible to losses (average performance = -1.26%) as their premium/discount values reverted (average change in premium/discount = -0.78%). However, neither the average performance or the average change in premium/discount values were found to be statistically significant. CEFs that were removed We next consider the 10 CEFs that underwent the largest decreases in allocation upon rebalancing. Those 10 CEFs had decreases ranging from -4.18% for BOE to -5.76% for BCX. The following graph shows the total return performance for those 10 CEFs from 1/2/2015 to 1/16/2015 (just over two weeks). BOE Total Return Price data by YCharts Those 10 CEFs had an average performance of -0.08%. The following table shows the premium/discount values for those 10 CEFs two weeks ago (1/5/2015) and today. CEFs are arranged in order of increasing premium/discount on 1/5/2015. Two weeks ago Today Change BCX -16.01 -15.23 0.78 BOE -13.30 -12.27 1.03 ETJ -10.19 -9.82 0.37 JGH -9.59 -12.62 -3.03 MIN -9.29 -8.01 1.28 ETW -9.04 -7.75 1.29 NFJ -7.61 -6.57 1.04 ETV -4.11 -3.54 0.57 GAB -3.85 -2.75 1.10 PHK 48.45 55.84 7.39 Average -3.45 -2.27 1.18 We can see that premium/discount value of these 10 CEFs increased by an average of 1.18%. The following chart displays the change in premium/discount values graphically, with CEFs arranged from the largest change to the smallest. We can see that 9 of the CEFs saw an increase in premium/discount value, while 1 of the CEFs saw a decrease in premium/discount value. Overall, these data appear to partially support the hypothesis that the CEFs that were removed from an index saw a suppression of value before rebalancing. While the majority of CEFs saw an increase in premium/discount value (average change = 1.18%), this did not translate into a higher performance (average performance = -0.08%). As before, neither the average performance or the average change in premium/discount values were found to be statistically significant. Personal trade I also described my personal trade in the previous article: At the open of 1/5/2015, I sold all but a token position in CEFL, and instead replaced the position with ETW, ETV, NFJ, PHK and PTY. All five CEFs were removed from the index, and the first four were among the top 10 funds undergoing the largest decreases in allocation. The following chart shows the total return performance for CEFL and those 5 CEFs from 1/2/2015 (the close of this day roughly corresponds to the open of 1/5/2015) to today (about two weeks). ETW Total Return Price data by YCharts Happily, my selection of CEFs that I purchased at the open of 1/5/2015 did much better than CEFL over the past two weeks. The average of the 5 CEFs was +0.59%, while CEFL fell -3.75%. Summary Two weeks after rebalancing, the 10 CEFs that were added to the index saw an average decline of -1.26%, while the 10 CEFs that were removed from the index saw an average decline of -0.08%. Meanwhile, 8 CEFs that were not substantially impacted by rebalancing exhibited an average gain of +0.35%. However, a statistical test showed that none of these average performances were significantly different from 0%, with the -1.26% decline for the 10 CEFs that were added being the closest to significance (p-value = 0.066). Moreover, we saw some evidence of mean reversion in premium/discount values taking place. The average change in premium/discount of the 10 CEFs that were added was -0.78%, while that for the 10 CEFs that were removed was +1.18%. However, these average changes were again not significantly difference from 0%. The difference between the average premium/discount change of -0.78% for the 10 CEFs added compared with +1.18% for the 10 CEFs removed was close to being significant (p-value = 0.069). Has mean reversion for these batch of CEFs been fully played out? For CEFs like AWP, the answer is probably yes, as its premium/discount dropped 4.48 percentage points (from -7.04% to -11.52%) over the course of two weeks, and is now once again close to its 1-year average of -11.21%. One must look at each CEF individually to evaluate its deviation from its historical premium/discount averages. Hopefully, we will have a chance to revisit this idea at the end of 2015 to see if the same phenomenon occurs or whether these artificial deviations, being now more well-known, will be arbitraged away.

A Conservative Way To Invest In An Energy Rebound

Summary BCX shares have been depressed after a recent closed-end fund merger because of selling by previous shareholders of BQR. BCX is trading at a 15% discount to NAV. BCX owns stocks with strong balance sheets which will be survivors if the energy bust continues. BCX uses an option writing strategy to reduce risk. Recent increase in VIX means higher options premiums and potential increases in the distribution rate. Many investors have been looking for a good way to benefit from a “bounce” in the energy sector. There are certainly big gains in store if you buy highly leveraged small cap energy stocks and if oil and gas prices quickly recover their losses. But there is also a risk that oil prices will stagnate for quite some time which would lead to many bankruptcies or restructurings in the energy sector. A safer way to invest in an energy rebound is to buy a diversified fund that mainly holds strongly capitalized large cap energy stocks that also hedge using an option over-writing strategy. There is one closed-end fund that currently trades at a 15% discount that fits into this category. The BlackRock Resources & Commodities Strategy Trust (NYSE: BCX ) seeks high current income and current gains, with a secondary objective of capital appreciation. The fund normally invests at least 80% of its total assets in equity securities issued by commodity or natural resources companies, or derivatives linked to commodity/natural resource companies. The fund generally invests in a portfolio of equity securities and utilizes an option over-writing strategy in an effort to seek total return performance and enhance distributions. On December 8, 2014, a three way fund merger was completed where BCF and BQR were merged into BCX. I believe that one cause for the currently wide discount to NAV is that some of the old shareholders of BQR are unhappy with the merger and have been selling their shares of BCX acquired via the merger. I wrote an article on BQR (Blackrock EcoSolutions) about a year ago. The fund was marketed as investing in companies that are “environmentally friendly”. A few weeks ago, I received a message from one of my Seeking Alpha readers who said he bought BQR as a long term investment because he liked their socially conscious investments and good dividend. Shortly after the merger was completed, he looked at his brokerage account and could no longer find BQR. After some digging, he realized it was replaced by BCX. In his words- “If it wasn’t so real I would think this is a cruel joke. Eco Solutions was replaced by Big Oil”. Distributions for BCX vary over time and were reduced late last year because of drops in the underlying portfolio value. The fund currently pays a monthly distribution of $0.0771. Because of weakness in the energy sector, tax loss selling and other selling by prior BQR/BCF shareholders, this may be a good time to buy BCX for bottom fishers or contrarian investors. The discount to NAV is -15.32% which is well above the six month average discount of -13.87%. The 6 month discount Z-score is -1.47, which means that the discount to NAV is about 1.5 standard deviations below the average discount over the last six months. The one year discount Z-score is also attractive at -1.46. Because of the relatively high distribution rate of 9.72% and high discount to NAV, you get to recapture a decent amount of the discount every year. Buying BCX at the market price and receiving NAV from a distribution is equivalent to a gain of 18% on those shares. Multiply this by the distribution rate and you get a discount capture “alpha” of about 1.75% per year. This is more than the annual expense ratio of 1.25%, so adjusted for discount capture, BCX has a negative expense ratio and the fund pays you to own it. Distributions for BCX vary over time and were reduced late last year because of drops in the underlying portfolio value. The fund currently pays a monthly distribution of $0.0771. But if there is a recovery in the energy sector, we could easily see distributions increase dramatically. The recent increase in options volatility, with the VIX above 20, should also benefit funds like BCX that use an options overlay strategy and could lead to a higher distribution rate as they capture the higher option premiums. BCX is more liquid than most other closed-end funds. It trades about $4.5 million a day and usually has a bid-asked spread of only a penny. In summary, BCX is currently a good holding for a patient investor who wants to participate in the energy sector, but wants to get paid a generous distribution while waiting for a rebound. There is good chance of a rebound in the NAV along with a narrowing of the discount within the next year. Top Industry Sector Holdings (12/31/2014) Energy 33.4% Agriculture 31.2% Mining 22.8% Other 10.5% Cash + Derivatives 2.0% Top 10 Holdings (12/31/2014) Exxon Mobil (NYSE: XOM ) 5.92% Chevron (NYSE: CVX ) 5.69% Monsanto (NYSE: MON ) 4.32% Conoco Phillips (NYSE: COP ) 3.89% Royal Dutch Shell (NYSE: RDS.A ) (NYSE: RDS.B ) 3.72% Rio Tinto (NYSE: RIO ) 3.40% Weyerhauser (NYSE: WY ) 2.56% Potash Corp. of Sask. (NYSE: POT ) 2.49% CF Industries (NYSE: CF ) 2.44% Syngenta (NYSE: SYT ) 2.41% Market Cap Breakdown (12/31/2014) Large Cap (> 10 bill) 79.2% Mid Cap (2-10 bill) 13.2% Small Cap ( < 2 bill) 5.5% Cash + Derivatives 2.0% Geographic Breakdown (as of 12/31/2014) United States 67.0% Canada 10.1% United Kingdom 9.2% Switzerland 2.5% Hong Kong 2.3% Cash + Derivatives 2.0% Norway 1.7% France 1.0% Japan 0.9% Australia 0.8% Ticker: BCX BlackRock Resources & Commodities Trust Pays monthly distributions Total Net Assets= $1,112 million Total Common assets= $1,112 million Monthly Distribution: $0.0771 ($0.9252 annual) Annual Distribution (Market) Rate= 9.72% Fund Baseline Expense ratio= 1.25% Discount to NAV= -15.23% Portfolio Turnover rate= 62% Effective Leverage: None Average Daily Volume: 469,000 shares Average $ Volume: $4,500,000 % Overwritten by Options= 23.82% Type of Options= Single Stock