Rethinking Risk Management Tactics For Closed End Funds

wall-street-etfMichael Fabian: Corrections in closed-end funds (CEF) begin just like any other asset class, driven by fear and discontent with the impending market landscape.  Yet I’ve come to observe many retail investors become disenchanted with even their most covetedholdings when a max-pain threshold has been reached.  In my opinion there are several reasons why investors struggle with swift ebbs and flows, but primarily I’ve found it stems from a lack of due diligence, proper planning, analysis, and portfolio management technique.  These factors can be offset with the proper perspective, and when understood correctly an investor can compound their future profits during times of heightened volatility.

Reassessing Risk Management

You might as well throw your traditional risk management tool kit out the window; these practices simply don’t work with a portfolio made up of closed end funds. Envision it this way, your goal of establishing an attractive cost basis relative to a fund’s NAV is in direct opposition to setting a hard stop-loss at a pre-determined price as a last-ditch means of capital preservation.  Even if you were to use a trailing stop-loss, an arbitrary percentage from the high is not likely to coincide with a good exit point if the fund only becomes more attractive as its price declines in relation to its NAV.

In contrast, evaluating a funds current price in relation to its historical NAV can act as a much better barometer of relative value than a simple percentage-change from your entry point.  This is especially true given the fact that most CEFs implement large distribution policies, which can manipulate a fund’s price compared to your stop-loss price. Prior trading history coupled with a good understanding of a fund’s fundamental traits make up the most basic due diligence that every investor should be innately familiar with.  These traits should include portfolio earnings, distribution coverage, underlying portfolio dynamics, fees, size, leverage, and management team.

When evaluating the risk of potential drawdown, an investor should start by analyzing a fund’s underlying asset mix, predetermine how volatile the assets can become during times of stress, and then finally factor in other influences such as leverage and the possibility of additional discount widening.  These basic steps will offer you a unique viewpoint on the attractiveness of the fund’s market price alongside the underlying portfolio holdings.  In addition, this exercise should give you a working model to calculate total portfolio drawdown if the worst outcome should ever enter reality.

Hedging Isn’t an Exact Science

When chatting with potential clients considering our Dynamic CEF Income portfolio, I’m often asked if we use hedges to offset portfolio volatility.  The first thought that typically enters my mind is: Hedge with what?  What index would you choose?

The S&P 500? Long term Treasuries? Credit Spreads? The volatility index? Or 3-month Libor? (Which is commonly tied to a fund’s leverage expenses).

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