Knowing When To Walk Away

etfsMichael Fabian: Unlike a typical portfolio of ETFs or mutual funds traded at NAV, closed-end fund investors must decide from a fundamental perspective if a fund’s risk will ultimately be worth the reward.  ETF or mutual fund assets are always redeemable at an underlying asset’s current price, so as an investor it becomes easy to make educated decisions when evaluating market trends alongside the funds you own.

The problem with CEFs is that even the most communicative fund sponsors report statistics that are 60-90 days stale.  So in turn, CEF investors are left to evaluate the daily relationship between NAV and market price trends to develop a cohesive portfolio.

This daily relationship allows us insight into yield curve positioning, duration, or targeted credit quality.  You then have to back out leverage and compare NAV price fluctuations to popular ETFs such as the iShares 7-10yr Treasury Bond ETF (IEF) or the iShares High Yield Corporate Bond ETF (HYG) to identify with the underlying portfolio manager’s intentions.

The bottom line is that you have to come to terms with the fact that you’re never going to get the entire picture; you are merely peering into a room through a keyhole.  Especially true with respect to swaps and other complex derivatives that can drastically change a portfolio’s dynamics.

The hard part is knowing when to walk away from an underperforming fund in what should be a nurturing market environment.

At our firm, we manage our Dynamic CEF Income Portfolio to capitalize on developing trends in the market, and some times that includes taking a countertrend viewpoint.   This was precisely the investment thesis when we assumed exposure to the Legg Mason BW Global Income Opportunities Fund (BWG).  The fund has an excellent long-term track record, distribution rate, dividend coverage, and even a rising dividend trend.  These characteristics meet or exceed all of our internal fundamental requirements.

We originally sought this fund out to play a countertrend move in the U.S. Dollar based on the fact that BWG has 65% of its underlying assets in alternative currencies such as the Euro, Mexican Peso, Brazillian Real, etc.   As most investors that follow currency fluctuations know, trends can last a long time.  Nevertheless, nearly every currency trend reaches at least a short-term tipping point.

Our timing on the entry point into BWG aligned well with the run-up and subsequent turnaround in the U.S. dollar.  Yet, after the dollar’s trend began to turnaround and accelerate to the downside, the NAV price movements in BWG were inconsistent in realizing the currency decline in the way we had anticipated.

All the while, we stuck with the trade despite the price of BWG grinding slightly lower in anticipation that the underlying portfolio dynamics could change.  However, we ultimately decided to step away from BWG in the first part of May as a result of a complete dislocation between our investment thesis and the reality of the fund’s price movement.

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