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Another EXG-ETW Pairs Opportunity Presents Itself

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

MORT And MORL Weighed Down By Smaller MREITs In 2015

Summary Despite their high yields, MORL and MORT have recorded negative total return performances in 2015. Surprisingly, the top 7 holdings of the fund all posted better YTD returns than the index. A number of smaller mREITs have fallen > 20% this year and may offer attractive entry points for the aggressive investor. Investors in the Market Vectors Mortgage REIT Income ETF (NYSEARCA: MORT ) and the 2x leveraged version, the UBS ETRACS 2x Leveraged Mortgage REIT ETN (NYSEARCA: MORL ), have not had a good year so far. Despite a recent rally triggered by the Fed’s decision not to raise interest rates, MORT is still down by -5.39% year-to-date [YTD], while MORL is down -12.5%. The iShares Mortgage Real Estate Capped (NYSEARCA: REM ), an ETF that tracks a different index than MORT/MORL, has performed slightly better at -4.00% for the year. MORL Total Return Price data by YCharts As an investor in MORL, I wanted to find out why the fund was doing so poorly. I first checked the YTD performance of Annaly Capital (NYSE: NLY ) and American Capital Agency (NASDAQ: AGNC ), the two largest constituents of MORT/MORL that together constitute nearly 25% of the index. However, neither stock has done as poorly as MORT. NLY has eked out a positive return of 1.89% in 2015, while AGNC is down by -3.41%. NLY Total Return Price data by YCharts I then checked the performance of the five next-largest constituents of MORT/MORL. Surprisingly, these five stocks have also all outperformed MORT. New Residential Investment Corp (NYSE: NRZ ) leads the pack with a YTD total return performance of +19.46%. STWD Total Return Price data by YCharts Summarizing the observations so far, the seven-largest holdings of MORL/MORT, which account for over half of the fund, have all outperformed the index. This suggests that the remaining constituents of the index have underperformed. To investigate this further, I obtained the weightings and YTD performance data of the 24 constituents of MORT/MORL from Morningstar . Note that the total return data may differ slightly from the YCharts graphs above. For the rest of the article, the Morningstar data will be used. Company Ticker % Assets YTD return / % Annaly Capital Management Inc NLY 14.70% 1.94% American Capital Agency Corp AGNC 10.21% -3.23% Starwood Property Trust Inc STWD 6.20% -2.28% New Residential Investment Corp NRZ 5.40% 22.32% Chimera Investment Corp CIM 5.37% -3.58% Two Harbors Investment Corp TWO 5.24% -0.10% Blackstone Mortgage Trust Inc BXMT 5.22% 3.47% Mfa Financial Inc MFA 4.42% -5.26% Hatteras Financial Corp HTS 4.36% -6.78% Colony Financial Inc CLNY 4.33% -5.00% Invesco Mortgage Capital Inc IVR 4.22% -6.14% Cypress Sharpridge Investments Inc CYS 3.95% -3.90% Pennymac Mortgage Investment Trust PMT 3.75% -17.88% Capstead Mortgage Corp CMO 3.12% -9.93% Apollo Commercial Real Estate Finance I ARI 3.02% 7.70% Armour Residential Reit Inc ARR 2.83% -21.81% American Capital Mortgage Investment MTGE 2.58% -6.61% New York Mortgage Trust Inc NYMT 2.58% -12.05% Redwood Trust Inc RWT 2.24% -20.96% Anworth Mortgage Asset Corp ANH 1.57% 2.86% Resource Capital Corp RSO 1.46% -27.83% Rait Financial Trust RAS 1.26% -22.82% Dynex Capital Inc DX 1.15% -14.79% Newcastle Investment Corp NCT 0.98% 13.59% The results above confirm my initial suspicion. While the top 7 holdings in the index (together accounting for over 52% of assets) had an average YTD performance of +2.65%, the remaining 17 constituents had an average performance of -9.27%. The data above is also shown in graphical form. There is weak positive correlation between % assets and % YTD return, indicating that the largest mREITs have outperformed the smaller mREITs so far this year. (The index uses a cap-weighted methodology, meaning that mREITs with a greater weighting in the index have larger market caps). The data is also shown in bar chart form below. We can see that most of the worst-performing mREITs lie on the right hand side of the chart, i.e. the big losers have all been smaller-cap mREITs. A notable exception is NCT, which is the smallest holding in the index but recorded a +13.59% YTD gain. Implications for investors What does this mean for mREIT investors? Firstly, we can see that there is a very wide dispersion in YTD return performances. NRZ has the best total return performance of +22.32%, while RSO has had the worst total return performance of -27.83%. However, past performance is no guarantee of future results, and investors uncomfortable with picking individual mREIT names may still prefer to remain diversified by investing in MORT/MORL. MORT has a trailing 12-months [TTM] yield of 11.07% and MORL has a TTM yield of 29.23%. Secondly, it is unclear whether the outperformance of large-cap mREITs vs. their small-cap brethren will persist into the future. The constant jitters and palpitations over a potential rate hike in 2015 may have unfairly punished small-cap mREITs, which are probably deemed to be more risky and volatile compared to their larger peers. However, this is just my rough guess, and more knowledgeable mREIT investors may have a better answer to this conundrum. A full analysis of the effect of interest rates on the performance of each mREIT is beyond the scope of this article. Finally, I hope that investors who are comfortable with selecting individual mREITs may still find the data useful. With further potential interest rate turmoil ahead, does one stick with the industry bellwethers NLY and AGNC which have weathered the storm so far in 2015? Or does one go bottom fishing with small-cap mREITs such as ARR, RWT, RSO and RAS that have all fallen more than 20% YTD, with the hopes of a rebound? The answer will depend on each investor’s risk appetite and interest rate outlook. Disclosure: I am/we are long MORL. (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.

Cushing MLP Total Return Fund: A Lesson For CEF Investors

Summary CEF investors are often attracted by the high yields in this space. SRV’s anomalously high yield and premium provided a ripe recipe for disaster. This article identifies three warning signals that investors could have heeded before the devastating event. The date is Dec. 22nd, 2014. With oil prices collapsing around you, you decide that now would be a good time to dip your toes in an MLP close-ended fund [CEF]. You read Stanford Chemist’s just-published article entitled ” Benchmarking The Performance Of MLP CEFs: Is Active Management Worth It? “, where he recommended, among five MLP CEFs yielding 5.43% to 6.85%, the Tortoise Energy Infrastructure Corporation ( TYG ) due to its strong historical total return and outperformance vs. the benchmark Alerian MLP ETF ( AMLP ). But the 5.43% yield of TYG and the 6.25% yield of AMLP are a bit low for your tastes. You decide to invest in the Cushing MLP Total Return Fund ( SRV ) with a whopping 14.02% yield , more than double that of the other two funds. With twice the yield, you might expect twice the return, right? Fast-forward to today. You have lost half of your investment. The following chart shows the total return performance of SRV, TYG and AMLP since Dec. 2014. SRV Total Return Price data by YCharts What happened to SRV? As with some other high-profile CEFs profiled recently, what transpired with SRV in early 2015 was a distribution cut that triggered a massive collapse in premium/discount value. As can be seen from the chart below (source: CEFConnect ), SRV slashed its quarterly distribution by 68%, from $0.2250 to $0.0730 in 2015. Amusingly, after paying one quarter of its reduced distribution, SRV cut its distribution again by 26%, while simultaneously changing to a monthly distribution policy (perhaps to make the second distribution cut less obvious!). Taken together, the overall change from a distribution of $0.2250/quarter to $0.0180/month represented a 84% reduction for SRV holders. (click to enlarge) The distribution cut was accompanied by a massive reduction in premium/discount value, from some +30% to -10%, as can be seen from the chart below. This explains the severe underperformance of SRV vs. TYG and AMLP since Dec. 2014. (click to enlarge) Obviously, hindsight is always 20/20. But I believe that there were some warning signs that SRV investors could have heeded before the disastrous event. Lesson #1: Consider historical performance While historical performance is no guarantee of future results, the past return of a CEF can give an indication of the management’s competency in running the fund. The 3-year total return to Dec. 2014 (the hypothetical start date of this exercise) shows that even before the distribution cut had occurred, SRV had been severely underperforming TYG and AMLP on a total return basis. SRV Total Return Price data by YCharts On a price-only basis, the underperformance of SRV becomes even more visually striking. SRV data by YCharts The above charts indicate that the high distribution paid out by SRV has prevented it from growing its NAV, despite the bull market in MLPs. Even when total returns are considered, SRV still lagged TYG and AMLP in the three years to Dec. 2014. Lesson #2: Premium/discount matters! As investors in the Pioneer High Income Trust (NYSE: PHT ) (see here for my previous article warning of PHT’s expanding premium) and more recently, the PIMCO High Income Fund (NYSE: PHK ), have found out , a high starting premium simply increases the amount that a fund can fall when adversity strikes. On Dec. 22nd, 2014, SRV’s premium/discount had stretched to a massive +28.4%. In comparison, TYG’s premium/discount was -6.1% at the time. The following chart shows the 3-year premium/discount profiles for SRV and TYG. (click to enlarge) The chart above shows that in the two years leading to Dec. 2014, SRV’s premium/discount expanded from around +15% to over +30%. On the other hand, TYG’s premium/discount declined from +15% to around -10% over the same time period. Does it make any sense to you that the perennial underperformer SRV was immune to the MLP sell-off that began in the summer of 2014, while the benchmark-beating TYG was not? No, it doesn’t make any sense to me either. In fact, SRV’s premium continued to expand even while the oil crash was already well underway. My only explanation for this was that retail investors were enamored with SRV’s high yield and pushed up its market price relative to its NAV. CEF expert and Seeking Alpha contributor Douglas Albo frequently laments the “Insanity of CEF Investors.” I believe that this example qualifies. Lesson #3: Beware of yields that seem too good to be true On Dec. 22, 2014, SRV yielded 14.02% with a premium/discount of +28.4%, meaning that its yield on NAV was even greater, at 18.00% (!). Meanwhile, TYG yielded 5.43% with a premium/discount of -6.1%, giving a NAV yield of 5.10%. Given that both funds employ similar leverage (around 30%), and are investing in essentially the same universe, how can SRV be yielding more than three times on its NAV compared to TYG? It just doesn’t make any sense. Simply put, SRV’s yield was way too good to be true. Summary I believe that there were several warnings signs that could have allowed investors to avoid SRV before the calamitous distribution cut in early 2015. These were [i] a poor historical performance, [ii] a rising premium (while other and better funds in the same category witnessed premium contraction), [iii] a yield that seemed way too good to be true. My main regret is not being able to identify this short opportunity for readers, and/or warn existing holders to exit the fund beforehand. Nevertheless, I hope that this article will help investors pick out similar warning signs in their existing or potential CEF investments to allow them to take action earlier. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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.