Did you know that closed-end funds (CEFs), a category of investment instrument, have existed for more than a century? Because of its long history, closed-end funds are a popular investing vehicle. But did you know that you can also make a closed-end fund trading strategy?
A closed-end fund trading strategy aims to buy low and sell high by using the discount or premium to the net asset value. We show you how in our backtest.
This article will offer insightful tips and helpful advice on using CEFs as part of your arsenal of trading strategies, whether you’re an experienced trader or new to CEFs. We end the article with a backtest of a closed-end fund trading strategy.
How Does a Closed-End Fund Work?
CEFs invest the money they receive from their initial public offering (IPO) in a diverse portfolio of securities. To fulfill the fund’s investment objective, the manager of the fund is in charge of overseeing the portfolio and making investment decisions.
Closed-end funds invest in many different asset classes: stocks, commodities, bonds, etc.
Leverage, which can boost returns and raise risk, is one of the primary characteristics of CEFs. The fund can invest more money than its owners have pledged thanks to leverage, achieved by borrowing money or issuing debt. As a result, there may be a trade-off between more significant returns and increased volatility because the fund’s performance is more closely correlated with the underlying securities.
Generally speaking, closed-end funds can give investors a chance to earn higher returns and income, but it’s crucial to thoroughly weigh the risks and potential disadvantages before participating.
Closed-End Fund Vs. Open-End Fund
Closed-end funds and open-end funds are two different types of investment vehicles that are available to investors. Both types of funds pool money from multiple investors to purchase securities, but they differ in how they raise and manage that capital.
A closed-end fund is a type of investment company that raises fixed capital through an initial public offering (IPO). Once the fund is closed to new investors, the fund’s shares are traded on a stock exchange like any other publicly traded stock. Unlike open-end funds, closed-end funds do not continuously issue new shares or redeem shares on demand.
On the other hand, open-end funds continuously issue new shares and redeem shares on demand. These funds are also known as mutual funds, regulated by the Securities and Exchange Commission (SEC), and require a board of directors and an independent auditor. The value of the fund’s shares is determined by the net asset value (NAV), which is calculated by dividing the fund’s total assets by the number of shares outstanding.
One of the critical differences between closed-end and open-end funds is that closed-end funds are often more leveraged, meaning that they use more debt to invest in securities. This can lead to higher returns but also higher risk. On the other hand, open-end funds tend to be less leveraged, which means they are less risky and have lower returns.
Closed-end funds typically invest in more “exotic” assets than open-ended funds.
What Are The Advantages of a Closed-End Fund?
Let’s look at some of the advantages of investing in a closed-end fund:
Closed-end funds often use leverage, which can lead to higher returns but also higher risk. Leverage always increases the risk of ruin. Plenty of closed-end funds ended up in deep trouble during the financial crisis in 2008.
Closed-end funds pay dividends to shareholders, which can provide a steady stream of income for investors. However, don’t fool yourself! A dividend always has an opportunity cost:
- Dividends vs. Retained Earnings (Why Retaining Earnings Is Better Than Dividends)
- Dividends Do Nothing For Shareholders
- Debunking Dividend Investing (Arguments Against Dividend Investing)
Closed-end funds shares are traded on the stock market, and their price is determined by supply and demand; this can lead to the shares trading at a discount to the net asset value (NAV) of the fund. Please have a look at our closed-end fund strategy backtest further down in the article.
What Is The Downside to Closed-End Funds?
Like all things in life, everything comes with a trade-off. It’s the same for a closed-end fund. These are some of the disadvantages:
Closed-end funds often use leverage which can lead to higher returns and risk. Using leverage increases the volatility of the fund’s returns and can amplify losses in a down market.
Closed-end funds have a fixed number of shares, and they are traded on the stock market; this means that the supply and demand determine the liquidity of the shares. This can make it more difficult to buy or sell shares of the fund, especially during times of market volatility.
Liquidity might also influence the premium or discount:
Closed-end funds shares are traded on the stock market, and their price is determined by supply and demand; this can lead to the shares trading at a premium or discount to the net asset value (NAV) of the fund. This can create a risk for investors if they are buying shares at a premium or selling shares at a discount. Some funds are always selling at a huge discount.
Largest Closed-End Funds
- PIMCO Dynamic Income Fund (PDI) – With assets under management of $4.4 billion, it is one of the largest closed-end funds in the market.
- BlackRock Income Trust Inc (BKT) – This is a closed-end fund that focuses on generating income through a diversified portfolio of bonds and other fixed-income securities. With assets under management of $3.7 billion, it is one of the largest closed-end funds in the market.
- Nuveen Municipal Value Fund Inc (NUV) – This is a closed-end fund that manages $3.2 billion, and they focus on investing in municipal bonds to generate income while also providing tax advantages.
- Nuveen Real Asset Income and Growth Fund (JRI) – This is a closed-end fund that focuses on investing in real assets such as real estate, infrastructure, and natural resources. They have assets of $2.9 billion under management.
- BlackRock Enhanced Equity Dividend Trust (BDJ) – With assets under management of $2.7 billion, this closed-end fund focuses on generating income through a diversified portfolio of dividend-paying stocks.
Oldest closed-end funds
- Boston Partners Long/Short Fund (BOS) – This is one of the oldest closed-end funds in the market, with a history dating back to 1929. The fund uses a long/short investment strategy, which means it can both buy and sell short securities in order to provide income and capital appreciation.
- BlackRock Income Trust Inc (BKT) – This is one of the oldest closed-end funds in the market, with a history dating back to 1929. The fund focuses on generating income through a diversified portfolio of bonds and other fixed-income securities.
- Gabelli Equity Trust Inc (GAB) – This is one of the oldest closed-end funds in the market, with a history dating back to 1999. The fund focuses on generating capital appreciation through a diversified portfolio of equity securities.
- Nuveen Municipal Value Fund Inc (NUV) – This is one of the oldest closed-end funds in the market, with a history dating back to 1986. The fund focuses on investing in municipal bonds to generate income while also providing tax advantages.
- PIMCO Dynamic Income Fund (PDI) – This is one of the oldest closed-end funds in the market, with a history dating back to 2008. The fund generates income through a diversified portfolio of bonds and other fixed-income securities.
Why Closed End Funds Trade At A Discount And Premiums
Closed-end funds are a type of investment vehicle traded on the stock market, like stocks.
One of the unique characteristics of closed-end funds is that their shares can trade at a premium or discount to the fund’s net asset value (NAV). The NAV is the value of the fund’s underlying assets divided by the number of shares outstanding. The share price of a closed-end fund, on the other hand, is determined by supply and demand in the stock market. Further down in the article we have a backtest that uses the discount as a buy trigger.
When a closed-end fund’s share price is trading at a premium to its NAV, it means that investors are willing to pay more for the shares than the underlying assets of the fund are worth. This can happen when the fund has a strong track record of performance or is part of a popular sector or trend. In this case, investors are willing to pay a premium for the potential for higher returns.
On the other hand, when a closed-end fund’s share price is trading at a discount to its NAV, it means that investors are willing to pay less for the shares than the underlying assets of the fund are worth. This can happen when the fund has a weak track record of performance or is part of a sector or trend that is out of favor. In this case, investors may be more cautious and willing to pay a lower price for the shares.
Closed-end fund trading strategy backtest – does it work?
Let’s look at a specific closed-end fund trading strategy backtest with 100% quantifiable trading rules and settings.
The closed-end fund we look at is Eaton Vance Tax-Advantaged Global Dividend Income Fund which has the ticker code ETG. We used to trade ETG from 2003 until 2009, but that was day trading, not swing trading, as in this backtest.
The net asset value of ETG can be downloaded using the ticker XETGX, for example, from Yahoo.
ETG seeks to invest in companies operating across diversified sectors, but the primary aim is to have a portfolio of dividend-paying value stocks/companies. ETG pays a monthly dividend and is meant for dividend investors (we are no fans of dividend investing as a strategy, see our post where we’re debunking dividend investing).
Our backtest relies on the net asset value reported by the fund daily. We calculate the discount or premium and base our buy or sell decisions on that.
The chart below shows the recent share price performance of ETG and the discount or premium in the lower pane:
ETG has mainly traded with a discount, but the discount has gradually diminished, and ETG has even been trading at a slight premium in 2022.
Let’s make a backtest. We make the following trading rules:
- When the 2-day RSI of the discount/premium ratio crosses below 10, we go long at the close.
- When the 2-day RSI of the discount/premium ratio crosses above 60, we sell at the close.
The strategy returned the following equity curve when we use daily bars:
The trading statistics and performance read like this:
- Number of trades: 207
- Average gain per trade: 0.48%
- CAGR: 4.8% (buy and hold: 6.8%, including dividends)
- Time spent invested: 14%
- Risk-adjusted returns: 35%
- Max drawdown: 26% (buy and hold: 74%)
- Profit factor: 1.6
Considering that the strategy spends so little time in the market, we believe the result is pretty good. If you have many different CEFs, you might manage a few uncorrelated strategies. Furthermore, the discount/premium is often not related to the general market movement, and thus you buy and sell unrelated to market conditions.
One obvious problem with our backtest is that we trade at the close, and the net asset value is unavailable at the time of the trade.
If we change the backtest to trade on the open the next day, we get the following equity curve:
The average gain per trade increases from 0.48 to 0.5%. but the drawdowns increase slightly.
List of trading strategies
We have written over 1000 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The code for the backtested closed-end fund strategy is included in the package.
The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.
The strategies also come with logic in plain English (plain English is for Python traders).
For a list of the strategies we have made please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
FAQs closed-end fund strategy
Let’s end the article with a few frequently asked questions:
Is it smart to invest in closed-end funds?
It depends on the individual investor’s goals and risk tolerance. It’s important to research the fund before investing. If you are unsure, please get in touch with your financial advisor.
When should you buy closed-end funds?
Timing depends on an individual investor’s financial goals and risk tolerance. Research the fund and market sentiment before buying.
Who should invest in closed-end funds?
Investors looking for higher returns, income through dividends, diversification, professional management, and buying shares at a discount.
But as always, you must do due diligence before you buy. That a fund trades at a discount doesn’t mean it’s a buying opportunity.
Why do so many closed end funds pay high dividends?
Closed-end funds often pay dividends to shareholders as a way to generate income. Remember that many funds must pay from shareholders’ equity when markets are troublesome.
A dividend seems like free money, but that is far from the truth! A dividend always has an opportunity cost.
Are CEFs better than ETFs?
It depends on the individual investor’s goals and risk tolerance. Both CEFs and ETFs have their own unique characteristics and advantages.
Should you buy a closed end fund when it’s trading at a discount?
It depends on the underlying reasons for the discount and individual investor’s risk tolerance. A discount is NOT a buying opportunity unless you know what you are doing.
Can you reinvest dividends in a closed end fund?
Yes, many closed-end funds offer the option to reinvest dividends.
Do closed end funds pay taxes?
Yes, closed-end funds pay taxes on any capital gains or income earned. Additionally, you might have to pay taxes on your dividends. A dividend is usually taxed, while capital gains taxes are delayed until realized.
How do closed-end fund expenses compare to other types of investment funds?
The expenses for closed-end funds may be higher than open-end funds but may be lower than some other types of investment funds. You must research the management costs before you invest.
Can investors buy and sell shares of closed-end funds on the secondary market?
Yes, closed-end funds shares are traded on the stock market so they can be bought and sold on the secondary market. They trade like any other stock with bid and offer prices.
Closed-end funds offer the potential for higher returns and income through dividends, but investors should research and fully understand the fund before investing. A dividend is usually taxable and limits other opportunities. Closed-end funds also come with higher risks.