Tag Archives: cefl

CEFL: A Year In Review, And A Prediction Of What’s Ahead

Summary 2015 has not been a good year for CEFL unitholders: income declined by 20% while price declined by 33%. This article presents a review of CEFL happenings in 2015, and a forecast of what’s ahead for 2016. Based on the publicly available index methodology, the CEFs to be added or removed are predicted. Introduction The ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) is a 2x leveraged exchange-traded note [ETN] that tracks twice the monthly performance of the ISE High Income Index [symbol YLDA]. The YieldShares High Income ETF (NYSEARCA: YYY ) tracks the same index, but is unleveraged. CEFL is a popular investment vehicle among retail investors due to its high income (24.52% trailing twelve months yield), which is paid monthly. With 2015 nearly behind us, I thought I would review the characteristics of this year’s iteration of CEFL, and also look ahead at what might be in store for us in 2016. (Source: Main Street Investor ) 2015 portfolio YLDA holds 30 closed-end funds [CEFs], and is rebalanced annually. As I have previously discussed in my three-part “X-raying CEFL” series, this year’s iteration of CEFL (and thus also YYY) had the following characteristics: CEFL is comprised of approximately one-third equity and two-thirds debt, is effectively leveraged by 240% and has a total expense ratio of 4.92% per dollar invested in the fund (or 2.05% per dollar of assets controlled) (discussed in ” X-Raying CEFL: Leverage And Expense Ratio Statistics “). CEFL contained around two-thirds of North American (primarily U.S.) assets, with the rest being international. Moreover, the North American component of CEFL contains a higher allocation to debt vs. equity than the European component of CEFL (discussed in ” X-Raying CEFL (Part 2): Geographical Distribution “). CEFL is not very interest-rate sensitive as most of the holdings of CEFL are most-correlated with high-yield debt (discussed in ” X-Raying CEFL (Part 3): Interest Rate Sensitivity “). Actually, I might have been inaccurate in my last prediction. Over the last year, the price action of CEFL has actually moved in the same direction to interest rates, which is exactly opposite to what would be expected for a traditional bond fund. But this is not entirely surprising for CEFL, because high-yield debt usually tend to trade in tandem with equities and in the opposite direction to treasuries. Indeed, CEFL had a positive +0.71 correlation with U.S. equities (via SPDR S&P 500 ETF (NYSEARCA: SPY ) over the past year, but a negative -0.24 correlation with treasuries (via the iShares 20+ Year Treasury Bond ETF) (NYSEARCA: TLT ) (source: InvestSpy ). Thus, readers who worried that higher interest rates would lower the price of CEFL may actually have been pleasantly surprised that the opposite has held true this year. Decreasing yield Seeking Alpha author Professor Lance Brofman has done a wonderful job predicting the upcoming distributions for CEFL (see his latest article here ), while also providing expert commentary in his area of expertise. The distribution history for CEFL, which now has paid out 24 months of dividends, is presented below. Unfortunately, we see that the distributions paid out by CEFL have been in decline. In 2014, each share of CEFL paid out $4.74 of distributions, but in 2015, each share of CEFL only paid out $3.82 of distributions. This means that the distribution of CEFL has declined by 19.5% year on year. I believe that a large reason for the distribution decline can be attributed to the rebalancing debacle that occurred at the turn of this year (see below). CEFL has a current trailing twelve months yield of 24.52%. Rebalancing debacle The annual rebalancing in the index YLDA was disastrous for CEFL and YYY holders. The reasons for this have been summarized in my recent article ” Are You Ready For CEFL’s Year-End Rebalancing ?” In short, up to 10% of the net asset value of CEFL may have been lost due to traders (including, perhaps, UBS themselves) buying and selling the CEFs to be added or removed from the index ahead of the actual rebalancing date (a form of “front-running,” see this Bloomberg article for more information on this phenomenon). For further study on the rebalancing issue, consult my previous articles on this issue in the below links: Predicting the 2016 portfolio How might the portfolio of CEFL change upon the next rebalancing event, which is scheduled to occur in the next few days? As discussed in my most recent CEFL article, the index provider has decided that upcoming index will not be announced 5 days in advance. This was intended to prevent “front-running” of the index. However, with the index methodology published and available to all, I had little doubt that professional investors would be able to use the selection rules to determine which stocks would be added or removed from the index. Therefore, in an attempt to level the playing field for everyone else, I have tried to approximate the index methodology in order to predict CEFL’s portfolio for 2016. The selection methodology for the index is reproduced below (source: ISE ). 1. Restrict selection universe to closed-end funds with market cap > $500M and six month daily average volume > $1M. 2. Rank each fund by the following three criteria: i. Fund yield (descending) ii. Fund share price Premium / Discount to Net Asset Value (ascending) iii. Fund Average Daily Value (ADV) of shares traded (descending) 3. Calculate an overall rank for each fund by taking the weighted average of the three ranks with the following weightings: yield: 50%, premium/discount: 25%, average daily value: 25%. 4. Select the 30 funds with the highest overall rank. Using CEFAnalyzer , I obtained a list of the 141 CEFs with market cap > $500M. Unfortunately, I was unable to apply a volume filter because I was not sure what specific time period CEFAnalyzer reports volume data for. I then replicated the index methodology for the 141 CEFs on this list. The below table shows the top 30 CEFs for either distribution yield or discount among the CEFs with market cap > $500M. Rank Ticker Yield Rank Ticker Discount 1 GGN 17.14% 1 BCX -16.92% 2 PHK 14.58% 2 AOD -16.88% 3 KYN 14.44% 3 AWP -16.29% 4 NHF 14.23% 4 IGR -16.19% 5 HIX 13.06% 5 FAX -16.09% 6 TDF 13.03% 6 RNP -15.64% 7 IGD 12.67% 7 GLO -15.33% 8 RVT 12.40% 8 RVT -15.07% 9 CEM 11.73% 9 NFJ -15.04% 10 PTY 11.69% 10 DPG -15.04% 11 GLO 11.37% 11 UTF -14.93% 12 GAB 11.21% 12 ADX -14.92% 13 EXG 11.17% 13 TY -14.81% 14 BCX 11.12% 14 WIW -14.79% 15 CHI 11.11% 15 TDF -14.63% 16 ETJ 11.05% 16 NXJ -14.58% 17 EAD 10.94% 17 NHF -14.57% 18 DSL 10.89% 18 NIE -13.63% 19 CHY 10.89% 19 NQP -13.40% 20 PFN 10.75% 20 USA -13.32% 21 PCI 10.74% 21 FSD -13.31% 22 FEI 10.44% 22 BIT -13.04% 23 ETW 10.36% 23 GDV -12.81% 24 AWP 10.24% 24 JQC -12.70% 25 NTG 9.95% 25 CAF -12.50% 26 PCN 9.86% 26 IGD -12.41% 27 CSQ 9.81% 27 VTA -12.33% 28 PDI 9.62% 28 RQI -12.27% 29 NFJ 9.62% 29 BDJ -12.10% 30 EVV 9.59% 30 NQU -12.04% The yield ranking was then weighted by 50% while the discount ranking was weighted by 25% (the rankings are assigned to all 141 CEFs, and not only to the top 30). The ranking for volume is not shown above because I was not sure about the time period used by CEFAnalyzer to calculate volume, as alluded to earlier. However, because I did not have time to manually calculate the ADV for 141 CEFs, the CEFAnalyzer data was still used to obtain a volume ranking for the funds, which was weighted by 25%. The weighted rankings were then summed, and the top 30 CEFs with the highest overall ranking are shown below, along with their composite individual ranks. A quick check on Yahoo Finance indicated that the 3-month ADV of these 30 CEFs was above the $1M cut-off (which is actually for the 6-month ADV, but I did not calculate this). Rank Ticker Yield Discount Volume Overall 1 (NYSE: RVT ) 8 8 18 10.50 2 (NYSE: BCX ) 14 1 25 13.50 3 (NYSEMKT: GGN ) 1 42 16 15.00 4 (NYSEMKT: GLO ) 11 7 39 17.00 5 (NYSE: NFJ ) 29 9 15 20.50 6 (NYSE: IGD ) 7 26 48 22.00 7 (NYSE: EXG ) 13 50 13 22.25 8 (NYSE: PCI ) 21 39 11 23.00 9 (NYSE: HIX ) 5 79 12 25.25 10 (NYSEMKT: EVV ) 30 35 17 28.00 11 (NYSE: DPG ) 33 10 38 28.50 12 (NYSE: AOD ) 44 2 24 28.50 13 (NYSE: NHF ) 4 17 96 30.25 14 (NYSE: DSL ) 18 77 8 30.25 15 (NYSE: CEM ) 9 100 5 30.75 16 (NASDAQ: CSQ ) 27 52 19 31.25 17 (NYSE: KYN ) 3 119 2 31.75 18 (NASDAQ: CHI ) 15 96 1 31.75 19 (NYSE: TDF ) 6 15 104 32.75 20 (NYSE: AWP ) 24 3 83 33.50 21 (NYSE: USA ) 31 20 58 35.00 22 (NYSE: BGB ) 36 46 26 36.00 23 (NYSE: NTG ) 25 88 6 36.00 24 (NYSE: FEI ) 22 97 7 37.00 25 (NYSE: BIT ) 47 22 32 37.00 26 (NYSE: UTF ) 54 11 29 37.00 27 (NYSE: BOE ) 40 41 30 37.75 28 (NYSE: GHY ) 39 47 27 38.00 29 (NYSE: ETJ ) 16 56 71 39.75 30 (NYSEMKT: FAX ) 41 5 72 39.75 At this point, I would like to compare notes with reader waldschm85 : I’ve attempted to follow the index methodology and came up with the below holdings from largest to smallest as of the open. How does this compare to your list Stanford Chemist?: BCX, TDF, GGN, RVT, KYN, PCI, NFJ, NTG, IGD, NHF, EXG, CSQ, GLO, DPG, CEM, , FEI, CHY, DSL, CHI, USA, HIX, PHK, GAB, TYG, EAD, ETJ, PTY, ETW, PFN, PCN Comparison of our two lists show that we have 20 out of 30 CEFs in common, which is quite high considering that [i] we did our analyses every days apart and [ii] I used an unspecified volume figure for ADV ranking while waldschm85 may have used a more accurate method. While the weighting methodology is too complex to be reproduced here, it can be noted that last year’s rebalance produced the CEF distribution shown below. The methodology states that no CEF can comprise more than 4.25% of the index. Additionally, the top 15 largest CEFs after last year’s rebalance all had weights of above 4%. I expect the weighting distribution of the 30 CEFs after this year’s rebalance to be quite similar to the last. Additions and deletions (predicted) Here we get to the interesting part! Which funds are completely new, and which will be completely removed? Which CEFs are in both 2015 and 2016 (predicted) portfolios? The following will be performed with my list of top 30 CEFs – obviously results will differ using waldschm85’s list or that of another person’s. CEFs are presented in alphabetical order. Added CEFs: BCX, BOE, CEM, CHI, CSQ, DPG, ETJ, FEI, IGD, KYN, NFJ, NHF, NTG, PCI, RVT, TDF, USA, UTF Removed CEFs: BGY, CHW, EAD, EDD, ERC, ESD, ETY, FPF, HYT, IGD, ISD, JPC, MRC, MMT, NCV, NCZ, PCI CEFs that remain from last year: AOD, AWP, BGB, BIT, DSL, EVV, EXG, FAX, GGN, GHY, GLO, HIX. The information above shows that 18 CEFs will be added to the index and 18 will be removed. 12 CEFs will remain in the index. This is a relatively high turnover but it is not unexpected given the fact that both the distributions and premium/discount values of CEFs can vary wildly. Moreover, given that I did not calculate weightings for the 2016 portfolio, I was unable to predict which CEFs will undergo the highest increases or decreases in allocation. However, it should be stressed that the above lists are only approximate. This is because I only performed a crude replication of the index methodology (specifically, I did not use the six-month ADV for either screening or ranking), and also because of the fact that the actual selection and ranking algorithm will be performed on CEF data at year-end rather than from today. Therefore, I am hesitant to recommend the buying of the CEFs to be added and the selling of CEFs to be removed as a potential strategy to profit from the upcoming rebalance. Use the information above at your own risk. Summary 2015 has not been a good year for CEFL unitholders. First, the botched rebalancing mechanism cause permanent loss of value in the index. Second, CEFL holders received 19.5% less income in 2015 compared to last year (this may be related to the first point). Third, CEFL shifted from a 60:40 equity:bond split in 2014 to a 33:67 equity:bond split this year, just in time for the oil-induced credit contagion to wreck havoc with the high-yield debt CEFs in the index. Certainly, a -32.7% YTD price return and -18.4% YTD total return cannot be described as anything other than disappointing for CEFL unitholders. CEFL data by YCharts Will 2016 bring brighter skies for CEFL? This I cannot say for certain. However, it is interesting to note that the predicted portfolio for 2016 contains several MLP CEFs, namely KYN, CEM, NTG, and FEI, whereas this year’s index contained none. Moreover, a myriad of high-yield bond funds will remain or are newly added to the predicted 2016 portfolio. Thus, it remains likely that the fate of CEFL will remain closely tied with the fortunes of the high-yield credit market for the foreseeable future.

Are You Ready For CEFL’s Year-End Rebalancing?

Summary The index for CEFL/YYY was last rebalanced in December 2014, and changes to the index were made public a few days before the event. Last year, heavy buying or selling pressure in particular index components forced CEFL/YYY to buy-high and sell-low, causing significant losses to CEFL/YYY unitholders. How will CEFL’s rebalancing be handled this year? Introduction The ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) is a 2x leveraged ETN that tracks twice the monthly performance of the ISE High Income Index [symbol YLDA]. The YieldShares High Income ETF (NYSEARCA: YYY ) is an unleveraged version of CEFL. CEFL is popular among retail investors for its high income, which is paid out monthly. (Source: Pro Spring Team ) YLDA holds 30 closed-end funds [CEFs], and is rebalanced at the end of every calendar year. The changes were publicly announced on the ISE website on Dec. 24, 2014, or about five days prior to the rebalancing event. According to YYY’s prospectus (emphasis mine): Index constituents are reviewed for eligibility and the Index is reconstituted and rebalanced on an annual basis. The review is conducted in December of each year and constituent changes are made after the close of the last trading day in December and effective at the opening of the next trading day . As CEFL is an ETN, it is not forced to buy or sell the constituent ETFs, but one would imagine that the note issuer, UBS (NYSE: UBS ), would be inclined to do so to hedge its exposure of the note. Rebalancing shenanigans Unfortunately, CEFL/YYY unitholders were hurt by the rebalancing mechanism last year. I first noticed that something was wrong when CEFL fell -2.96% (and YYY -1.25%) on Jan. 2nd, 2015, a day where both stocks and bonds held relatively steady, and where the comparable PowerShares CEF Income Composite Portfolio ETF (NYSEARCA: PCEF ), an ETF-of-CEFs that tracks a different index, rose +0.21%. A bit of detective work on my part revealed that the CEFs that were to be added to the index received heavy buying pressure in the days between the index change announcement and rebalancing day, while the CEFs that were to be removed came under tremendous selling pressure. This caused the prices of the added CEFs to rise significantly during that period, which was topped off by an upwards price spike on rebalancing day, while the prices of the CEFs to be removed declined markedly in price, culminating in a downwards spike on rebalancing day. As a consequence, the index and hence YYY were forced to “buy high and sell low” on rebalancing day, causing about 1.3% of the net asset value [NAV] of YYY to be vaporized in an instant. This findings were presented in my Jan. 4th article ” Frontrunning Yield Shares High Income ETF YYY And ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN CEFL: Could You Have Profited ?” However, the pain was not over for CEFL/YYY holders. The upwards price spike of the CEFs to be added on rebalancing day occurred on top of the artificially-inflated prices caused by the buying pressure days before the actual event. After rebalancing, the added CEFs possessed premium/discount values dangerously above their historical averages, as I warned in ” Beware Reversion In YieldShares High Income ETF And ETRACS 2x Closed-End Fund ETN ,” leading to further losses as the premium/discount of those CEFs reverted back to their original levels. How much were CEFL/YYY investors hurt? How much were CEFL/YYY holders hurt by last year’s rebalancing mechanism? It is impossible to provide an exact number, but here is my estimate. The 10 added CEFs with the largest increases in allocation rose by 2.96% in one week, while the 10 with the largest decreases in allocation declined by -3.38% in one week (as presented in my Jan. 4th article). Assuming that CEFL is equally-weighted*, these events would have caused an overall 2.11% decline in asset value. Up to a further 1.25% was lost on rebalancing day due to price spikes. Moreover, the 10 CEFs that were added to the index declined by 1.26% two weeks after rebalancing as mean reversion possibly took place (as discussed in ” 2 Weeks Later: Did Mean Reversion Of CEFs Take Place? “), contributing a further 0.42% decline of the index, again assuming equal-weight. This sums to a 3.8% loss for YYY holders, or about a 7.6% loss for CEFL holders, not an insignificant amount. Note that this number is likely to be an underestimate because only the top 10 CEFs undergoing the highest increases and decreases in allocation were considered. In actuality, 19 funds were added, and 17 were removed. *(CEFL is actually not equal-weighted, but it is not entirely top-heavy either. See my Jan. 4th article linked above for details to the index weighting methodology). An alternative methodology for calculating the underperformance of CEFL/YYY is to simply compare the performance of YYY to PCEF, as both are ETFs-of-CEFs, but track different indexes. As analyzed in ” Has CEFL Done As Badly As It Looks? ” YYY underperformed PCEF by a total of 5.3% in the months of December and January, i.e. the months surrounding the rebalancing date. Although this approach is only approximate (as the exact composition of the two funds differ), it does produce a number that is on a similar order of magntitude as the 3.8% loss calculated with the first approach. Either way you cut it, a 4% or higher loss for the index/YYY (double that for CEFL, due to leverage) because of factors outside of “normal” market behavior hurts. Moreover, the fact that the index was forced to buy high and sell low necessarily results in a lower income for the fund going forward, as the fund would not have been able to purchase as many shares of the new CEFs than it “should” have been entitled to. Indeed, each share of CEFL paid out a total of only $4.03 in 2015, down from $4.40 in 2014, representing a 8.5% decrease in income paid for the year. I lost…so who won? So if CEFL/YYY unitholders were hurt during rebalancing, who profited? Most likely, it was the savvy investors who purchased the CEFs to be added to the index and shorted the CEFs to be removed as soon as the index changes became public. This could, in fact, include UBS themselves, who are free to adjust their hedges for CEFL anytime they like (because CEFL is an ETN rather than an ETF), and not only on rebalancing day. This creates an ironic situation in which the act of UBS adjusting their hedges at more favorable prices before rebalancing could have actually and directly hurt investors in their very fund. Why is this a problem for CEFL and not other funds? The main problem appears to be the lack of liquidity for CEFs, as well as the fact that arbitraging price differences for CEFs can be risky as they often trade at premium or discount values around their intrinsic NAV, meaning that it would be difficult for arbitrageurs to determine the “true” value of a CEF. An insightful comment from a reader in my previous article reveal that this has happened to other funds as well, and also illustrates a possible solution to this problem: [We] also had a FTSE 100 tracking fund run externally by a well known global indexing house. I recall at one index rebalance, said fund had a MOC order to buy one of the new index constituents, and ended up paying about 25% MORE than the prevailing market price was 1 minute before. All index tracking funds got completely shafted as guess what, the next day the stock was back down to the price it was before its index inclusion. … Some index managers get friendly brokers to ‘warehouse’ stocks (take them onto their own book) for a few days, buying them up ahead of inclusion in a particular index, the fund then takes an average price, and doesn’t get the shaft with a MOC order. It can lead to a bit of ‘tracking error’ mind you. This time it’s…different? As a CEFL unitholder and with the end of the year rolling around, I thought I would refresh myself on the rebalancing mechanism of the index YLDA to confirm exactly when the CEF changes would be announced, so that I could…uh…you know…get in on the frontrunning action and profit at the expense of fellow CEFL/YYY holders. Just kidding, I would have definitely shared this information with all my loyal readers! (Please do click the “follow” button next to my name if you haven’t done so already if you enjoy my ETF analysis.) So I fired up the YLDA methodology guide and looked for the rebalancing date… and looked, and looked…only it wasn’t there! I then checked the date of issue of the methodology guide: December 4th, 2015. So this couldn’t have been the guide I was reading when I was writing my earlier CEFL articles this year. Luckily, I had a version of the guide stashed in my downloads folder, and the relevant section (4.3) is dutifully reproduced below (emphasis mine): 4.3. Scheduled component changes and review ( OLD v1.2 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. Component changes are made after the close on the last trading day in December , and become effective at the opening on the next trading day. Changes are announced on ISE’s publicly available website at least five trading days prior to the effective date . How does this compare with the current version of the methodology (emphasis mine)? 4.3. Scheduled component changes and review ( NEW v1.3 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. The index employs a “rolling” rebalance schedule in that one third of component changes are implemented at the close of trading on each of the first, second and third trading days in January of the following year and each change becomes effective at the opening on the second, third and fourth trading day of the new year, respectively. No prizes for spotting the difference! Not only has the statement about the announcement of changes been removed, the rebalancing is now not performed all at once at the close of the last trading day in December, but is now equally spread through the first, second and third trading days of the following year. I then used the free PDF comparison tool ( DiffPDF ) to scan for any additional changes to the methodology between last and this year’s. Besides being nearly foiled by the addition of two blank pages in this year’s edition, the software showed that, besides the aforementioned change in Section 4.3, a similar statement to the above had been removed from the index description in Chapter 2: Chapter 2. Index Description ( bold sentence in OLD guide only ) Companies are added or removed by the ISE based on the methodology described herein. Whenever possible, ISE will publicly announce changes to the index on its website at least five trading days in advance of the actual change . No changes were made to the constitution or weighting mechanisms of the fund. Appendix B of the current document lists the entirety of the changes as “Rebalance revision (4.3).” What does this mean for investors? Analysis of the old and new methodology guide reveals two major changes: The changes to the index will not be public beforehand. Instead of rebalancing the components all at once, the rebalancing will be conducted in three equal parts spread across three days. What does this mean for investors? I believe that the first change is well-intended, but may ultimately prove fruitless. The methodology for index inclusion and weighting is relatively complex, but is publicly available (it’s found in the methodology document), and I have no doubt that professional investors will be able to determine the changes even before they happen. In fact they may be doing this right now as I am writing this, and also later, when you are reading this. The second change is, I believe, a positive one, but only if it means one of two possible ways that one could construe “one-third.” The guide states that ” one-third of component changes are implemented… on each of the first, second and third trading days in January .” So if 10 CEFs have to be added to the index, does it mean that 33.3% of the total dollar value of the 10 CEFs will be purchased on each of the three days? In this case, the liquidity situation will be improved because each CEF will be purchased over three days. This would decrease the likelihood of a price spike occurring upon rebalancing (presumably by YYY, the ETF), which ameliorates the buy-high sell-low situation faced by the index last year. If instead, it means that 4 CEFs will be 100% purchased on the first day, 3 on the second, and 3 on the third, then unfortunately I don’t think that the liquidity situation will improve, as the trading in each CEF is still going to be concentrated in a single day, despite the fact that different CEFs may be spread out on different days. What do readers think about how this sentence should be interpreted? So, it appears that this time may actually be different. However, personally, I’m not waiting around to find out. I’ve recently sold all but a single share of CEFL to keep my interest in the fund, and replaced it with several better-performing CEFs (such as the PIMCO Dynamic Income Fund (NYSE: PDI )), as recommended in Left Banker’s article here .

CEFL Still Attractive With 21.9%Yield

My projection of a $0.2758 monthly dividend for CEFL would result in a 21.9% yield on an annualized compounded basis. The weighted average discount to book value for the closed-end funds that comprise CEFL is less than it has been recently, but it is still substantial. The action by UBS to not issue any new notes of its outstanding ETRACS ETNs, which included CEFL, does not impair the credit or liquidity of CEFL. The enormous discount to book value than many of the closed-end funds has lessened somewhat. Last month, all 30 of the index components of the UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ), and the YieldShares High Income ETF (NYSEARCA: YYY ), which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, traded at discounts to book value. They are still trading at discounts to book value now. From the inception of CEFL until two months ago, there were always some component closed-end funds trading at premiums to book value. Two months ago, two of the components were trading at premiums to book value. The discount to book value is not as large as it was a month ago. On a weighted average basis, the closed-end funds that comprise CEFL are trading at a 11.77% discount to book value as of October 23, 2015 as compared to 13.8% a month ago. The median discount for the 30 closed-end funds is 12.41% as compared to 14.25% a month ago. Thus, the case for CEFL based on the large discount to book value still exists, but is less compelling than it was previously. There has been some confusion regarding the decision by UBS AG (NYSE: UBS ) that it does not intend to issue any new notes in 38 of its outstanding ETRACS ETNs. These include CEFL. UBS stated in an October 8, 2015 press release : “…This announcement does not affect the terms of the outstanding Series A ETRACS ETNs identified below, including the right of noteholders to require UBS AG to redeem their notes on the terms, and at the redemption price……. In connection with the previously announced transfer by UBS AG to UBS Switzerland AG of specified assets, UBS Switzerland AG became a co-obligor of all outstanding debt securities designated as Series A, including the Series A ETRACS ETNs, issued by UBS AG prior to the transfer date…” This in no way impairs the rights or liquidity of CEFL and there are now two stated co-obligors for the ETNs, which if anything improves their credit. However, Fidelity now does not allow its customers to buy the Series A ETRACS ETNs. This has caused some confusion and inconvenience for Fidelity customers and some frustration for Fidelity employees who realize this prohibition makes very little sense. However, as far as I know, no other brokerage firm has prohibited its customers from buying the UBS ETNs. Closed-end funds typically trade at either discounts or premiums to book value. On balance, there is a slight bias towards discounts. Because of significant changes in the composition of the index, comparisons of aggregate discounts to book value from previous years are not very meaningful. That said, the 13.8% discount last month was the largest since the inception of CEFL. Six months ago, CEFL had an 8.6% weighted discount to book value. Thus, in just five months, the discount had increased from 8.6% to 13.8%, but has since come down to 11.77% For many securities other than closed-end funds, such as common stocks, discounts or premiums to book values are logically based on the business prospects for companies. Thus, Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) trades at significant premium to book value, while Peabody Energy (NYSE: BTU ) trades at a significant discount to book value, reflecting differing market perceptions of the future prospects for those companies. Google trades at approximately 5X book value while BTU trades at about one-fifth of book value. In my article: mREITs Impacted By Enormous Price To Book Swing – MORL Yielding 27.6%, I discussed the large discounts to book value that mREITs such as American Capital Agency Corp. (NASDAQ: AGNC ) are trading at. The logic behind mREITs such as AGNC trading at significant discounts to book value is primarily based on the possible impacts of higher future interest rates. Whether one agrees or disagrees with the magnitudes of the discounts or premiums to book for securities such as Google, Peabody and AGNC there are facts and logic related to each company’s business prospects that could possibly explain or justify changes in the premiums or discounts that have occurred in those stocks. There are no such facts or changes in market forecasts of business prospects that can possibly explain or justify changes in the premiums or discounts that have occurred in the closed-end funds that comprise CEFL. For closed-end funds, changes in the premiums or discounts to book value should be solely based on the value that investors place on the relative advantages and disadvantages of the closed-end fund structure, rather than the differing market perceptions of the future prospects for the securities in the closed-end funds’ portfolios. Investors in closed-end funds could purchase the securities held by a closed-end fund themselves. In most cases, there are also open-end funds available to investors that have risk, return and expense characteristics similar to any given closed-end fund. Changes in market perceptions of the prospects of the securities that comprise the portfolios of closed-end funds cannot logically explain or justify any change in the magnitudes of the discounts or premiums to book for the closed-end funds. Any such changes in market perceptions of the prospects of the securities in the portfolio should be reflected in the prices of the portfolio securities themselves. Thus, the ratio of the price of the closed-end fund to its book value should not be related to the expectations of the prospects for the portfolio securities held by the closed-end fund. If investors value the advantages of diversification, management and possibly lower transaction costs associated with owning a closed-end fund rather than owning the individual securities that comprise the closed-end fund’s portfolio more than the fees and expenses, which are the primary negative aspect of closed-end funds, then the closed-end fund will trade at a premium to book value. Conversely, if investors feel that the fees and expenses of the closed-end fund outweigh the advantages of diversification, management and possibly lower transaction cost associated with owning a closed-end fund, it will trade at a discount to book value. The trade-offs between the advantages and disadvantages associated with closed-end funds relative to the securities that comprise the portfolios of the closed-end funds are rational reasons for the closed-end funds to trade at discounts or premiums to book value. However, it is not rational for the discount or premium to be influenced by expectations of future returns on the securities that comprise the portfolios of the closed-end funds. If the market thinks that the securities in a closed-end fund’s portfolio will decline, and thus the net asset or book value of the closed-end fund will decline, there is no reason why the premium or discount that the closed-end fund is trading at should change. Some closed-end funds employ limited amounts of leverage. As investment companies, closed-end funds cannot have more than 33% leverage and most employ less, if any. That a closed-end fund does or does not employ a relatively small amount of leverage should not impact the premium or discount that the closed-end fund is trading at. Leverage is the easiest characteristic of a security to offset. Thus, if an investor was interested in a security but did not like the fact that the security employed 20% leverage, the investor could offset that leverage by combing that security with a risk-free asset. For example, if you had $10,000 to invest and you liked a closed-end fund but were unhappy with the 20% leverage, investing $8,000 in the closed-end fund and $2,000 in a risk-free asset will result in the same risk/return profile as investing $10,000 in the same closed-end fund, if that fund did not employ any leverage. Likewise, if you liked a closed-end fund but would rather that fund employed more leverage, you can buy that fund on margin and get in the same risk/return profile as investing in the fund if it had more leverage. Thus, leverage or lack of leverage should not influence the premium or discount that the closed-end fund is trading at since any leverage in a closed-end fund can be offset by an investor. There should be some limits as to how far away from book value a closed-end fund should trade. If a closed-end fund is trading at a sufficiently high premium to book value, an arbitrage opportunity could exist. Buying the securities in the closed-end fund’s portfolio and simultaneously selling the closed-end fund should generate a profitable arbitrage. Likewise if a closed-end fund is trading at a large enough discount, buying the closed-end fund and selling the securities that comprise the portfolio, it could generate arbitrage profits. These types of arbitrage would be risk arbitrage as opposed to riskless arbitrage. In riskless arbitrage, one buys a security or commodity and simultaneously sells something that is the equivalent of what you sold. An example of riskless arbitrage would be after a merger had been approved in which the acquirer is issuing one share of its stock for two shares of the company being acquired, you simultaneously buy two shares of the company being acquired for a total cost less than a share of the acquirer. This would essentially lock in a profit that would be realized when the merger closed and the values converged. Attempting to take advantage of the discount to book value being irrationally wide for a closed-end fund would be an example of risk arbitrage since there is no terminal event that will make the value of what you buy converge with what you sell. It may be irrational for a closed-end fund to trade at a 10% discount to book value. However, there is always the possibility that it could go to a 15% discount. As Keynes famously said, “The market can stay irrational longer than you can stay solvent.” Closed-end funds do not usually provide convenient opportunities for explicit risk arbitrage transactions where one security is bought and the other security is shorted. Retail investors usually cannot use the proceeds from selling some securities short to buy other securities. Hedge funds and institutions that may be able to use the proceeds from selling some securities short to buy others might find closed-end funds, and especially some of the securities that comprise the portfolios of the closed-end funds, not liquid enough to trade in. Even market participants who are able to use the proceeds from selling some securities short to buy others might be dissuaded from buying closed-end funds and shorting the securities in the closed-end funds’ portfolio, because of the fees and expenses charged by the closed-end funds. However, if the discount to book value is large enough, the fees and expenses charged by the closed-end funds could be offset by the discount to book value and thus generate a positive carry for a long closed-end fund — short the fund’s portfolio position. This would be especially true for closed-end funds that specialize in securities that generate higher income, such as those in the index upon which CEFL and its unleveraged counterpart YYY are based. An example of the discount to book value more than offsetting the fees and expenses would be a hypothetical closed-end fund whose portfolio securities yielded 10% before expenses. Most income-oriented closed-end funds have expense ratios lower than 1%. Shorting $100 worth of the securities that comprise the fund would require payments of $10 representing 10% annually to those who the securities were borrowed from. The $100 proceeds from the short sale could be used to acquire $100 of the closed-end fund. If the closed-end fund was trading at a 14% discount, $100 of the fund would represent 100/.86 = $116.28 worth of the securities in the fund. These securities yield 10%, so the gross income from the fund position would be $11.63. The net income, assuming a 1% expense ratio, would be $10.63. Thus, even after expenses and fees, an account long the closed-end fund would generate higher income than the portfolio securities while it waited for the discount to narrow to realize the risk arbitrage profit. While explicit risk arbitrage where the portfolio securities are shorted and the proceeds are employed to buy the closed-end fund might not occur in significant quantities to narrow the discount to book value, implicit arbitrage should eventually have an impact. Implicit risk arbitrage would occur as investors holding or wanting to hold securities with similar risk/return characteristics as a closed-end fund or the portfolios held by the closed-end fund shift from other securities to the closed-end fund. Institutional investors who had portfolios that contained securities similar to or identical to those held in a close-end fund could improve their risk/return profile by shifting out of securities in the closed-end fund to the closed-end fund, if the discount to book value for the closed-end fund was large enough. Retail investors could switch from securities held in portfolios of close-end fund to the closed-end fund and improve their risk/return profile if the discount to book value for the closed-end fund was large enough. More important, investors could shift out open-end mutual funds into closed-end mutual funds with similar objectives and portfolios. Open-end mutual funds are sold and redeemed at net asset value. Thus, there is never any discount or premium to book value for an open-end mutual fund. Advantages for investors in no-load mutual funds are that there are no transactions costs and the funds can always be redeemed at net asset or book value. Closed-end funds usually require some brokerage commission to buy and sell them, and there is risk that the closed-end fund will fluctuate due to changes in the premium or discount to net asset value in addition to fluctuation in the portfolio securities. The advantages of no-load open-end mutual funds are somewhat offset by the lower fees and expenses that closed-end funds usually have. When closed-end funds are trading at large discounts to book value, investors can significantly increase their returns by switching from open-end funds to closed-end funds that have similar assets but are selling at discounts to net asset value and typically have lower fees and expenses. When an investor redeems an open-end fund at net asset value, the open-end fund sells portfolio securities to fund the redemption. That would tend to lower the market prices of those portfolio securities. If the investor uses the proceeds from the redemption of the open-end fund to buy shares in a closed-end fund that holds similar portfolio securities, the net effect would be to put downward pressure on the market prices of the portfolio securities and upward pressure of the market prices of the closed-end funds. Thus, the discount to book value for the closed-end funds will tend to decline. This large discount to net asset value alone is still a good reason to be constructive on CEFL. Although with the discount receding, the case is not as compelling as previously. It should be noted that saying CEFL components are now trading at a deeper discount to the net asset value of the closed-end funds that comprise the index does not mean that CEFL does not always trade at a level close to its own net asset value. Since CEFL is exchangeable at the holders’ option at indicative or net asset value, its market price will not deviate significantly from the net asset value. The net asset value or indicative value of CEFL is determined by the market prices of the closed-end funds that comprise the index upon which CEFL is based. My constructive view on CEFL stems not only from the wide discount to book value of the closed-end funds, but also from the very large dividends paid by CEFL. One troubling aspect of CEFL is the significant amount of the dividends paid by the closed-end funds that comprise CEFL that consists of return of capital. My calculation using available data indicates that 18.5% of the November CEFL dividend will consist of return of capital. Another caveat is that, as is shown in the table below, some of the closed-end funds have not officially declared their monthly dividends with ex-dates in October 2015. All of those have declared the same monthly dividend for at least the last five months. I have assumed they will declare the same dividend in October as they did in the last five months. Of the 30 index components of CEFL, and YYY, which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, 29 now pay monthly. Only the Morgan Stanley Emerging Markets Domestic Debt Fund (NYSE: EDD ) now pays quarterly dividends in January, April, October, and July. Thus, EDD will not be included in the November 2015 CEFL monthly dividend calculation. My calculation projects an November 2015 dividend of $0.2758. This is an decrease of 6.1% from the September 2015 dividend of $0.2938, which also did not include any contribution from EDD. While the 2014 year-end rebalancing has reduced the monthly CEFL dividend, it is still very large. For the three months ending November 2015, the total projected dividends are $0.8733. The annualized dividends would be $3.4932. This is a 20.0% simple annualized yield with CEFL priced at $17.49. On a monthly compounded basis, the effective annualized yield is 21.9%. Aside from the fact that with a yield above 20%, even without reinvesting or compounding, you get back your initial investment in only five years and still have your original investment shares intact. If someone thought that over the next five years markets and interest rates would remain relatively stable, and thus CEFL would continue to yield 21.9% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $269,233 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $21,900 initial annual rate to $58,962 annually. CEFL component weights as of as of September 30, 2015, prices as of October 23, 2015 Name Ticker Weight Price NAV price/NAV ex-div dividend frequency contribution return of capital First Trust Intermediate Duration Prf.& Income Fd FPF 4.91 21.72 23.56 0.9219 10/01/2015 0.1625 q 0.0128 Eaton Vance Limited Duration Income Fund EVV 4.55 13.15 15.11 0.8703 10/8/2015 0.1017 m 0.0123 MFS Charter Income Trust MCR 4.49 8.2 9.36 0.8761 10/13/2015 0.06276 m 0.0120 0.0628 Doubleline Income Solutions DSL 4.45 17.9 20.04 0.8932 10/14/2015 0.15 m 0.0130 Blackrock Corporate High Yield Fund HYT 4.4 10.37 11.82 0.8773 10/13/2015 0.07 m 0.0104 0.0012 Clough Global Opportunities Fund GLO 4.38 11.31 13.02 0.8687 10/14/2015 0.1 m 0.0135 PIMCO Dynamic Credit Income Fund PCI 4.34 18.9 21.8 0.8670 10/7/2015 0.164063 m 0.0132 Prudential Global Short Duration High Yield Fundd GHY 4.33 14.53 16.59 0.8758 10/14/2015 0.11 m 0.0115 Alpine Total Dynamic Dividend AOD 4.27 8.04 9.47 0.8490 9/21/2015 0.0575 m 0.0107 Eaton Vance Tax-Managed Global Diversified Equity Income Fund EXG 4.23 9.15 9.97 0.9178 10/21/2015 0.0813 m 0.0131 0.0659 Alpine Global Premier Properties Fund AWP 4.18 6.22 7.32 0.8497 9/21/2015 0.05 m 0.0118 Western Asset Emerging Markets Debt Fund ESD 4.13 14.37 17.06 0.8423 10/21/2015 0.105 m 0.0106 0.0146 Eaton Vance Tax-Managed Diversified Equity Income Fund ETY 4.13 11.3 12.04 0.9385 10/21/2015 0.0843 m 0.0108 ING Global Equity Dividend & Premium Opportunity Fund IGD 4.04 7.69 8.6 0.8942 10/1/2015 0.076 m 0.0140 0.0266 BlackRock International Growth and Income Trust BGY 3.86 6.55 7.17 0.9135 10/13/2015 0.049 m 0.0101 0.0417 GAMCO Global Gold Natural Resources & Income Trust GGN 3.75 5.84 6.21 0.9404 10/14/2015 0.07 m 0.0157 Prudential Short Duration High Yield Fd ISD 3.5 14.87 17.01 0.8742 10/14/2015 0.11 m 0.0091 Aberdeen Aisa-Pacific Income Fund FAX 3.39 4.74 5.59 0.8479 10/19/2015 0.035 m 0.0088 0.0147 Morgan Stanley Emerging Markets Domestic Debt Fund EDD 3.37 7.57 9.04 0.8374 9/28/2015 0.22 q MFS Multimarket Income Trust MMT 3 5.88 6.75 0.8711 10/13/2015 0.04517 m 0.0081 0.0452 Calamos Global Dynamic Income Fund CHW 2.89 7.71 8.76 0.8801 10/7/2015 0.07 m 0.0092 Backstone /GSO Strategic Credit Fund BGB 2.78 14.38 16.76 0.8580 9/21/2015 0.105 m 0.0071 0.0012 Blackrock Multi-Sector Income BIT 2.15 16.34 18.95 0.8623 10/13/2015 0.1167 m 0.0054 Western Asset High Income Fund II HIX 2.09 6.86 7.59 0.9038 10/21/2015 0.069 m 0.0074 0.0006 Allianzgi Convertible & Income Fund NCV 1.86 6.38 6.96 0.9167 10/8/2015 0.065 m 0.0066 Wells Fargo Advantage Multi Sector Income Fund ERC 1.75 12.03 14.07 0.8550 9/11/2015 0.0967 m 0.0049 0.0283 Wells Fargo Advantage Income Opportunities Fund EAD 1.38 7.86 8.91 0.8822 9/11/2015 0.068 m 0.0042 Nuveen Preferred Income Opportunities Fund JPC 1.29 9.28 10.26 0.9045 10/13/2015 0.067 m 0.0033 Allianzgi Convertible & Income Fund II NCZ 1.15 5.69 6.2 0.9177 10/8/2015 0.0575 m 0.0041 Invesco Dynamic Credit Opportunities Fund VTA 0.98 10.87 12.55 0.8661 10/13/2015 0.075 m 0.0024