The fundamental problem with CEFs is premium to discount volatility which is more closely correlated to equity market volatility than the volatility of the strategy.

Savvy investors may see opportunity in CEFs trading at a discount to NAV, but should also consider that the CEF pricing mechanism adds an additional layer of volatility to their investments. Such additional volatility reduces risk-adjusted returns. The Nasdaq HANDLS indexing solution addresses this drawback by providing exposure only to ETFs that allow for creations and redemptions, which reduces the risk that the market price of an ETF share will deviate from its NAV.

By dramatically reducing premium / discount volatility, the Nasdaq HANDLS indexing solution helps investors to earn better risk-adjusted returns than if they gained the same investment exposure through a CEF or a fund that invests in CEFs.


1/9/2018, "A New Way to Income", Cohen & Patterson, @CNBC.com
PCEF YYY FCEF CEFS

Matthew J. Patterson and David I. Cohen

June 3, 2019

For years investors have relied upon closed-end funds (CEFs) to access leveraged-income strategies and high managed-distribution policies. At the end of 2018, CEFs held approximately $250 billion in assets under management and exchange-traded funds (ETFs) that invest in CEFs represented a $1 billion plus category.

While some ETFs of CEFs have built solid long-term track records (the Invesco CEF Income Composite ETF carries a five-star Morningstar rating), they nevertheless incorporate the most undesirable feature of CEFs: a pricing mechanism that adds an additional layer of volatility to the CEF’s underlying portfolio of investments.

Like ETFs, CEFs issue shares that trade on an exchange. Unlike ETFs, CEFs offer no means for market makers to create or redeem shares to ensure that they trade at approximately the same price as their net asset value (NAV). Consequently, CEFs may trade at market prices that differ significantly from their underlying NAVs. While some CEFs trade at a premium to their NAV, most tend to trade at a discount to NAV.

Of critical importance to investors is that a CEF’s discount (or premium) to NAV fluctuates over time, meaning investors experience additional volatility from the CEF pricing mechanism that is incremental to the volatility of the CEF’s underlying portfolio.

Investors seeking to access leveraged-income strategies and high managed distribution policies can eliminate volatility associated with the CEF pricing mechanism by investing in strategies that use ETFs. The Nasdaq 7 HANDL Index provides leveraged exposure to a portfolio of ETFs representing an approximate allocation of 70% fixed income / 30% equity.

To illustrate the impact the CEF pricing mechanism can have, we looked at CEF pricing data for the largest CEFs for the period from January 1, 2018 through February 28, 2019 with the objective of extracting price changes associated with changes in the discounts (or premiums) to NAV for the CEFs. We then adjusted the returns of a leading CEF index, the S-Networks Composite Closed-End Fund Index, to illustrate what its returns for the period would have looked like without the price changes associated with the CEF pricing mechanism.

The following chart illustrates the performance of the S-Networks Composite Closed-End Fund Index, the adjusted version of the same index and the Nasdaq 7 HANDL Index for the period from January 1, 2018 through February 28, 2019.

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While the average discount to NAV for the CEF universe was approximately the same at the beginning and end of the time period reflected in the chart below, it widened significantly in the fourth quarter of 2018 as the stock market experienced significant declines. During this period, the S-Networks Composite Closed-End Fund Index significantly underperformed the adjusted version of the same index that strips out price changes associated with the CEF pricing mechanism. When the stock market rallied in the first two months of 2019, the average discount to NAV for the CEF universe reverted to normal levels and the performance of the S-Networks Composite Closed-End Fund Index caught up with its adjusted version.

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The following table compares the total return performance from January 1, 2018 to February 28, 2019 of the Nasdaq 7 HANDL Index to the S-Networks Composite Closed-End Fund Index and the adjusted version of the S-Networks Composite Closed-End Fund Index that strips out price changes associated with the CEF pricing mechanism.

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Although all three indexes delivered comparable positive returns, the Nasdaq 7 HANDL Index achieved the highest total return with the least amount of volatility. Stripping out price changes associated with the CEF pricing mechanism eliminated about 27% of the volatility associated with the S-Networks Composite Closed-End Fund Index. Investors seeking to maximize risk-adjusted returns should consider the impact of the CEF pricing mechanism when evaluating leveraged-income strategies and recognize that an investment in CEFs is as much a tactical call on the direction of the average discount as it is a strategic investment in the underlying asset class.

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