Tuesday, August 5, 2014

Paper: "Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient Than You Thought"

Saw a new paper on CEF arbitrage, "Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient Than You Thought" by Dilip Patro, Louis R. Piccotti, and Yangru Wu.

"We find significant evidence of mean reversion in closed-end fund premiums. Previous studies substantially understate the magnitudes of arbitrage profits in the closed-end fund market. Capitalizing on the property of mean reversion, we devise a parametric model to estimate expected fund returns by incorporating the information content of a fund’s premium innovation history. Our strategy of buying the quintile of funds with the highest expected returns and selling the quintile of funds with the lowest expected returns yields an annualized arbitrage return of 18.2 percent and a Sharpe ratio of 1.918, which are substantially higher than the corresponding figures produced using the extant methods. The results are robust to a wide range of tests. They greatly deepen the closed-end fund discount puzzle and pose a challenge to the market efficiency in these products."
I'm sure they are right that there is mean reversion in CEF premiums. That's why we like the muni-CEFs right now, trading at in some cases record-wide discounts, all because of interest rate paranoia.

However, I don't see that this paper considered the cost to borrow the premium CEFs.That would be a difficult thing to study, as there is no dataset that I'm aware of on historical borrowing costs.

The stock lending market is too opaque, borrowing costs are too high, leading to not enough stock being shorted and prices being less accurate than they should be. However, short selling is "bad," so there is no political pressure to clean up the stock lending market.


Anonymous said...

Locating stock to borrow is nearly impossible, let alone at an affordable rate.

CP said...

Activist arbitrage: A study of open-ending attempts of closed-end funds

Tool for screening ~700 closed end funds.

The Persistence and Predictability of Closed-End Fund Discounts

Special Opportunity Fund [SPE]

Of course, any mention of arbitrage strategies now requires a discussion of the stock lending market. It's hard to make money waiting for a 10 or 15% valuation disparity to converge when you are going to get gouged for half of that, annually, to borrow the stock for the short leg of the trade.