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I’ve received questions from prospective subscribers about the types of trade alerts that we issue to the members section of the Cambridge Income Laboratory. One type of trade is CEF arbitrage, or more specifically a pairs trade, where we simultaneously identify an overvalued CEF and an undervalued CEF in the same sector. The strategy then entails selling or selling short the overvalued fund while simultaneously buying the undervalued fund.
The advantage of a CEF pairs trade is that because both the sold and bought funds are from the same sector, we aren’t making a directional bet on the performance on the underlying assets. Instead, we’re simply relying on the powerful concept of reversion of CEF premium/discount values (see Reflections On Chemist’s CEF Report Pick Performance In 2017 for how this has worked well for us in the Chemist’s monthly CEF picks).
There are two main limitations of the CEF arbitrage strategy. The first is that the magnitude of the gains are unlikely to be very large, simply because it is by nature a hedged strategy. That’s the trade-off for the strategy being relatively low risk. The second limitation is that unless you already own the overvalued CEF identified in the pairs trade, you would have to locate shares of the overvalued CEF to sell short. With some of the smaller, less liquid CEFs, this can range from expensive to downright impossible. The most optimal set-up is therefore already owning the overvalued CEF, and then locking in profits by selling the fund and then replacing it with the undervalued CEF in the same sector.
With the introductory blurb out of the way, let’s see how this has played out for one of the more recent CEF pairs trade that we identified in the members section of the Cambridge Income Laboratory.
About 4.5 months ago (see Sell This Investment Grade Income CEF Now), we noticed the premium of Western Asset Income Fund (PAI), an investment grade bond CEF, suddenly spiking up to +10.16%. The 1-year z-score was +3.6, indicating that this fund was significantly more expensive than its recent history. My comments from the initial article are reproduced below:
I was looking through the CEF database today and noticed the Western Asset Income Fund (PAI) trading at an exceptionally high z-score of +3.6.
Its current premium of +10.16% is at a 5-year high.
A 1-year z-score of +3.6 tells us that the premium/discount is trading 3.6 standard deviations above its 1-year historical value. Statistically speaking, this would be a 0.02% probability of occurrence, assuming that the distribution of values is normally distributed (which it isn’t, but the point is that such a high z-score is a rare occurrence).
The 5-year chart above showed that the fund traded at quite substantial discounts over the past 5 years, sometimes exceeding even -10%. This makes the current premium of +10.16% even more unusual than the 1-year z-score of +3.6 would indicate.
At this juncture, I wanted to look at the entire history of the CEF since inception. Perhaps the past 5 years was just an anomaly, and that the CEF has commanded a consistent premium in the past? It turns out that was not so.
Going back to inception, only during a brief period in 2009 did the fund’s premium exceed 10%. An unusually high premium for an investment grade fund might be understood during the immediate recovery period after the financial crisis…but why now? I can’t think of a fundamental reason why someone would pay $ 1.10 for a dollar of investment grade debt.
I then check out the premium/discount values of the peer group. Maybe investment grade bond CEFs are for some reason on a tear thus accounting for PAI’s unusual premium? Nope, that’s not it.
The premium of PAI is 3rd-highest out of the 15 CEFs in the “investment grade” category of CEFConnect. But I don’t consider PIMCO Corporate & Income Strategy Fund (PCN) and PIMCO Corporate & Income Opportunity Fund (PTY) to be traditional investment grade income CEFs, so not counting those two funds PAI has the highest premium in the peer group.
(Source: Stanford Chemist, CEFConnect)
OK, so PAI is a pretty good sell or short candidate. What did I pair my short PAI position with?
What did I pair my short PAI position with? I chose the BlackRock Credit Allocation Income Trust (BTZ). I wanted to choose a fund with a negative z-score, but rather amazingly all 15 investment grade CEFs had z-scores 0 or greater. BTZ’s z-score of +0.8 wasn’t the lowest, but its discount of -9.04% was the widest in the peer group, as you can see from the chart above.
Next, I wanted to see compare the price and NAV returns of these two investment grade bond CEFs to check if there were signs of deteriorating portfolio values in the undervalued CEF, which might cause me to consider BTZ as the long partner in this pairs trade.
The opportunity for the pairs trade comes from the fact that PAI’s price return is significantly outpacing its NAV return, whereas that is not the case with BTZ. We can see from the chart below that PAI appears to be blowing BTZ out of the paper with a +19.29% YTD return compared to only +8.94% for BTZ.
However, their YTD NAV returns are nearly identical.
No warning signs there. That leads me to the conclusion that:
In summary, if you own PAI, now would be a great time to sell!
Let’s see how the thesis played out 4.5 months later. BTZ had a total return loss of -3.88% over this time frame. That’s bad, of course, but still relatively much better than PAI’s loss of -14.1% over the same period. In other words, BTZ outperformed PAI by 10.22 percentage points in only 4.5 months, or about 27% annualized.
Did PAI’s portfolio do much worse than BTZ’s? No, and in fact the reverse was true. PAI’s net asset value [NAV] fell by -2.10% over this time period, but BTZ’s was even worse at -3.24%.
If BTZ’s portfolio did worse than PAI’s, why was its total return (much) better? My regular readers will have already guessed at the answer: premium/discount mean reversion! Over the last 4.5 months, PAI’s premium of +10.16% has sank to a discount of -4.82%, while BTZ’s discount of -9.04% has widened slightly, to -11.9%. Therefore, the majority of the outperformance of the long BTZ/short PAI pairs trade was due to the contraction of PAI’s discount.
This article hopefully conveys our thought process in recommending a pairs trade to our members. Anyone who owned PAI and swapped to BTZ to would have profited to the tune of ~10% in only 4.5 months (~27% annualized), which is equivalent to about 2.5 years worth of distributions from PAI!
Note that I did not need to do a deep dive analysis of either PAI or BTZ to initiate this pairs trade. This was based almost entirely on premium/discount mean reversion, or as my fellow SA author Arbitrage Trader likes to say, “simple statistics”.
Taking stock of the situation today, the long BTZ/short PAI trade has to be considered to be largely completed, as PAI is now trading with a discount of -4.82% and a 1-year z-score of -1.5, indicating that is now cheaper than its historical average. Although BTZ’s z-score of -2.5 is even lower, as is its discount (-11.9%), the gap in valuation is no longer there.
Are there any current opportunities? The following table shows the 12 CEFs in the database that currently have z-scores greater or equal to +2.5. If you own ones of these funds, if might be a good idea to seek out another fund in the same category that is trading with a more attractive valuation, particularly if the fund that you own is also trading at a premium. Don’t let mean reversion catch you out!
|MS Income Securities||(ICB)||2.71%||-1.47%||3.9|
|BlackRock Science and Technolo||(BST)||5.32%||3.05%||3.2|
|Tortoise MLP Fund||(NTG)||8.61%||9.26%||3.2|
|ClearBridge Energy MLP||(CEM)||8.85%||5.53%||3.1|
|Gabelli Utility Trust||(GUT)||8.50%||44.95%||3.1|
|Templeton Emerging Mkts Income||(TEI)||3.79%||-8.17%||3.1|
|Sprott Focus Trust||(FUND)||4.97%||-8.86%||3.0|
|Nuveen S&P Dynamic Overwrite||(SPXX)||5.58%||9.54%||2.9|
|RiverNorth Opportunities Fund||(RIV)||12.09%||6.83%||2.7|
|Deutsche High Income Oppos||(DHG)||5.42%||-0.60%||2.6|
|First Trust New Opps MLP & En||(FPL)||10.52%||6.67%||2.5|
Western/Claymore Infl-Lnk Opps
(Source: CEFConnect, Stanford Chemist)
Cambridge Income Laboratory: CEF and ETF Income and Arbitrage Strategies
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We’re currently offering a limited time only free trial for the Cambridge Income Laboratory. Prices are going up on March 1, 2018, so please join us and lock in a lower rate for life by clicking on the following link: Cambridge Income Laboratory.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: I am long the portfolio securities.
I wear the same thing every day. My banking is 100% automated. Once a year, I go to Costco and stock up on an entire year’s worth of essentials. My wife thinks I’m a little OCD (and you probably do too!) … but I firmly believe systematizing my life has made me more successful.
I run my life the same way I run my company: with streamlined systems and processes to guarantee success. You can’t go in blind and expect to land in the right place; you need to be planful, create a vision, and establish actionable ways to achieve your goals. It’s not for everyone, but I believe we all can benefit from implementing systems into our day-to-day lives.
There’s a System For That
Entrepreneurs spend so much time building out processes to keep their business running like a well-oiled machine. These systems are the nuts and bolts of everything the business does; without them, the whole thing would fall apart.
Few of us apply the same mentality to our personal lives. Most people are insanely busy all the time — myself included. I run four companies, I have three kids, and I value my personal time, too. The more tasks I can systematize, the more time I have to focus on everything that matters.
Take packing, for example. Most people make a new list every time they pack, but that’s just not efficient: not only are you wasting time on a repetitive task, you also run the risk of forgetting something. I travel a lot so I have a ready-made list that I use every time. This way, I don’t have to overthink it and the process is more efficient. Systematizing my life is about being purposeful with my time and never wasting a minute.
Systems Are Reliable — and Fixable
I’ve always believed in Michael Gerber’s sentiment, “People don’t fail, systems do.” Systems are meant to function cohesively and to set you up for success; if something goes wrong, it can almost always be traced back to a glitch somewhere.
I schedule my working days down to the minute — from the moment I wake up to when I go to sleep. This allows me to maximize my time so there’s never a second wasted, not even my commute: my assistant schedules all my phone calls for when I’m driving, so I can be just as productive enroute as I am in-office. (Don’t worry, I’m always hands free!). If I tried to squeeze calls into my office hours, I’d never get anything done.
It comes down to your mindset: when you start looking at each aspect of your life as a distinct system, it becomes easier to identify, address and streamline for the future.
A Systematized Life is a Simplified Life
Over the years I’ve learned that the less complicated the system, the more likely it is to work. That’s why our systems for our businesses are incredibly simple — as in, they fit on one page. Anyone who reads our operations manual can run a successful franchise. I apply this same philosophy to my life.
How’s this for a simple system: I wear the same jeans, T-shirt and Chucks almost every day. It’s my way of removing an unnecessary step from my life. The less time I waste on decisions like what to wear, the more time I have for more important things like my family and the business.
Maybe it’s because I’m a minimalist, but inefficiency is one of my biggest pet peeves. I swear it’s not just an oddball quirk; being efficient lets you spend less time working and more time living. After all, a simple life is a happier life.
Here’s a sad story I see all the time. I see a hellbent content creator commit a ton of time, for the sake of being consistent, only to create so-so content that nobody cares about. How many company blogs do you know publish multiple times a week and receive a total of zero comments and zero shares on their articles? They spend time and money to write a story that nobody reads. It’s sad.
To fix this, I want to give you a framework to help you create outstanding content, the kind of stuff that truly gets noticed and talked about.
Note: for the most part I’ll be referring to blog posts, but this principle applies to nearly any type of content.
Your audience wants one of two things from all of your content: to learn or to be entertained. That’s it. Delete everything else that doesn’t accomplish one of these outcomes.
It might sound simple to you, but if you use this as a filter before you publish anything, the quality of your content will skyrocket, the chances of it taking off will increase, and your audience will grow.
In the paragraphs below, I want to show you why this is true and how to implement it. The takeaway is this: The best content either teaches something new to a reader, or causes them to feel a strong emotion.
If you look at every piece of successful or viral content, you’ll find they do one of these things with masterful excellence.
Option One: Teach Something New
With over 942,000 followers on LinkedIn, Jeff Haden’s columns on Inc.com regularly appear in the top 10 articles of each month, with readership frequently surpassing a total of 500,000/month. He is a prolific blogger and knows what works and what doesn’t.
He said one of the biggest mistakes bloggers make is preaching to the choir. “I already know what I think, and so do you. Readers want to learn new things and take new perspectives. They want to think. Agreeing is nice, but agreeing never makes them think.”
So be careful: If you have trouble coming up with a clear answer to the question “what will my readers learn from this?”, then you should seriously consider reworking the piece. In other words, viral content provides incredible value for the reader. Make sure there are actionable takeaways, sharp insights, nuggets of wisdom, step-by-step processes, helpful resources, and / or efficient tools.
Someone reading this might be thinking, but how do I know if my work is actually providing value?
While I’ve written several top articles on Medium, been paid rates of a dollar per word, and been published at major publications like CNBC, Axios, Thought Catalog, The Next Web, and Business Insider, not everything I write goes viral. Not even close. As much as I improve, I’m still quite adept at writing terrible articles. Some of my worst articles appear on my personal blog daveschools.com. Here are two examples:
- What it feels like to finish a novel
- I cared more about people, then projects, and now it’s back to people. I think.
These will never go viral for a couple reasons. First, poor headlines. Second, if you start reading them, it will be a matter of seconds before your brain taps you on the shoulder and asks, “Why in the world are you reading this?” Because your brain is picking up on a clear fact: they don’t teach you anything. You won’t learn anything helpful from them. It’s just one person who doesn’t have you in mind blubbering on about their life. These will never, ever be shared on social networks.
Let’s look at an example of an article that did go viral and why:
My most successful Medium article ever, I sat down with a millionaire who operates 10 businesses while sailing around the world with his family, which was the 7th most popular story on Medium in 2015, was syndicated by Business Insider, Quartz, MIT, and Fortune Magazine. It was successful because it gave five helpful, uncommon insights from an expert that taught small business owners new ways to manage their businesses better.
This single sentence was highlighted 528 times:
“To be successful in business does not mean changing the world. It means meeting a need (regardless of size) well and dependably over time.”
In five minutes, readers learned something new from this article. This should be the utmost goal of anything you write. Teach something new. Unless, of course, you are trying to entertain. This is the second option.
Option Two: Evoke Strong Feelings
Look at this non-educating and almost offensive article: F*** You Startup World.
It’s a bitter beatdown, wild rant, and brutal slamming against modern startup culture.
It teaches you nothing and yet it received 370,000 views in one day, one million views total (and counting), and more than 80,000 shares on Facebook. Why did it do so well? It didn’t really teach anyone anything and it contains 95 f-words! What happened?
This article illustrates the power of emotion.
Readers resonate deeply with the author, relate strongly to his experience, and say, “This is exactly what I’ve been feeling and someone has finally put into the right words.”
Humans are emotional. They read to feel something strong. Your job as the writer is to make them laugh, let them sob, trigger them to righteous anger, or wash away their loneliness. You don’t have to teach them anything, you just have to deeply affect them. Inspire them. The right words have a way of unlocking pent-up emotions we never realized we had.
Your Turn: How to Apply This Filter to Your Content
Remember that there is no formula or single style of content that guarantees success. Your challenge is to find out how to teach or entertain in your own unique and original voice.
- Study Gary Vaynerchuk, Tim Ferriss, and Mike Allen for examples of how masters create learning content.
- To watch experts create entertaining content, analyze standup comedians and read Mr. Trump’s tweets (joking), but seriously, read novels, even some news articles, and first-person accounts of big events to see writers reach strong feelings.
After you’ve written something, edit it with this test in mind. Does it do a good job teaching a concept? How can it be clearer? Does it do a profound job of moving the reader’s emotions? How can it be more passionate?
Edit, edit, edit until there’s no doubt in your mind that the piece accomplishes one of these two outcomes. Ultimately, if you apply this binary test to your thinking, it will help get you closer to creating wildly successful pieces of content.
Best of luck. Because, in all honesty, you’ll need a little bit of that, too.