Author’s note: this article was released to members of CEF/ETF Income Laboratory on June 28, 2020.

How CEF Rotation Can Turn Losers Into Winners

As our long-time members would know, closed-end fund rotation a.k.a. “compounding income on steroids” is one of the bread-and-butter strategies that we employ at the CEF/ETF Income Laboratory. The reason this is such a powerful strategy is that no market timing is required, meaning that we can generate “free shares” of our favorite positions not matter whether the markets are up, down or sideways! This leads to supercharged compounding because you can grow your share count through CEF rotation, in addition to through the reinvestment of distributions. Our members have a step-by-step guide on how to execute this strategy, see this guide here: How Would You Like Your Free Shares To Be Served? (Double-Compound Your Income!)

To illustrate just how powerful our strategy can be, I will use the example of our rotation trades between two CLO equity funds, Oxford Lane Capital Corp (OXLC) and Eagle Point Credit Company (ECC), in our Income Generator portfolio over the last three months.

There are several reasons for choosing this pair for our illustration.

First, we were able to complete a double round-trip (OXLC–>ECC–>OXLC–>ECC–> OXLC) in just over 3 months, allowing us to see how quickly share counts can compound using this strategy.

Secondly, it has been no secret that CLO equity funds have taken it on the chin this year due to the COVID-19 pandemic and the resulting shutdown affecting vast swathes of the economy. The charts of OXLC and ECC since March 12 (the start point of our analysis) to June 26 are not pretty, with price losses of -27.40% and -32.07% compared to a +20.93% rebound for the S&P 500 (SPY). But as we’ll see below, our rotation strategy can turn even such “losers” into “winners”.

Chart

Data by YCharts

Third, this pair nicely demonstrates how even if members don’t catch the exact price of the trade alerts, that the profits can still be very substantial. I know that some members have expressed frustration that the prices move so quickly after our trade alert is released, which is an unfortunate side effect of our community getting larger. But the levels of alpha we are generating can cover a lot of slippage and still leave room for a lot profits to spare!

The Trades

Here are the trades that our Income Generator portfolio made in the OXLC/ECC pair since March 12:

  • March 12: Our Income Generator portfolio owned 1250 shares of OXLC that closed at $5 (worth $6250).
  • April 3: Sell 1,250 shares of OXLC at $3.93 ($4913) to buy 970 shares of ECC at $5.06 ($4908)
  • May 28: Sell 970 shares of ECC at $7.60 ($7372) to buy 2,350 shares of OXLC at $3.12 ($7332)
  • June 1: Sell 2350 shares of OXLC at $4.19 ($9847) to buy 1,380 shares of ECC at $7.11 ($9812)
  • June 19: Sell 1,380 shares of ECC at $7.03 ($9701) to buy 2,700 shares of OXLC at $3.59 ($9693)

In just over 3 months, our share count in OXLC has grown from 1,250 shares to 2700 shares (+116%), which is an absolutely incredible result. Remember, we did this without DRIPing, i.e. we harvested all of the distributions in cash. (We also withdrew $88 from these trades due to our rounding of share counts to the nearest 10).

Image result for free sharesThis share count increase completely dwarfs the -27% share price decline of OXLC over the same time frame, and in fact the price return of our CLO equity position since March 12 to June 26 is a superb +58.50%, nearly tripling SPY’s +20.93% return. And that’s not even counting the distributions that we have received in the meantime!

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Turning Free Shares Into Cash

If you were offered “free shares” of your favorite fund, would you take it? I know I would. However, I do understand that some members may not wish to increase their exposure to the risky CLO equity sector. Fortunately, it is also possible to harvest the “free shares” in the form of cash by only rotating enough of the sold fund to maintain the same share count in the purchased fund that you had previously. The remaining proceeds from the sold fund can be retained as hard cash.

Here’s the numbers on how that would have worked out with our initial share count of OXLC:

  • March 12: Our Income Generator portfolio owned 1,250 shares of OXLC at $5 (worth $6250).
  • April 3: Sell 1250 shares of OXLC at $3.93 ($4913) to buy 970 shares of ECC at $5.06 ($4908) –> withdraw $5 in cash
  • May 28: Sell 970 shares of ECC at $7.60 ($7372) to buy 1,250 shares of OXLC at $3.12 ($3,900) –> withdraw $3472 in cash
  • June 1: Sell 1250 shares of OXLC at $4.19 ($5238) to buy 735 shares of ECC at $7.11 ($5226) –> withdraw $12 in cash
  • June 19: Sell 735 shares of ECC at $7.03 ($5167) to buy 1,250 shares of OXLC at $3.59 ($4488) –> withdraw $679 in cash

Notice how we’ve kept the number of shares of OXLC the same at 1,250 after each rotation trade with ECC, which would allow us to withdraw the difference as hard cash.

Overall, $4168 in cash would have been withdrawn over these 3 months from a starting capital of $6250, representing a +66.7% return in 3 months! Remember, this number doesn’t even include any cash distributions received during this time either!

You don’t have to catch the exact price of the trade alert to make good profits

As our community grows, it is inevitable that our trade alerts will have more impact on the markets. What this means is that it may be difficult for members to get the exact price of the buys and sells that our portfolios do. I know that this has been source of frustration for some of our members who are trying to follow the portfolios and it is something that I can completely empathize with. However, I don’t think it’s something to get too worked up about, and here’s why.

1. Trade alert effects cancel out alot of the time

While there is some bias towards prices worsening after our trade alerts, it is by no means an inevitable event. Sometimes prices also get better after our trade alert! I believe that for the majority of the times, these effects cancel out. When we analyzed this for our portfolios last year, we found that the overall effect of slippage on performance was relatively minor, a -73 bps drag for the Tactical Income-100 portfolio in 2019 H1 if trades were conducted at the close instead of the trade alert price, and a -32 bps drag for the Income Generator portfolio.

For the OXLC/ECC swaps that we did in the Income Generator portfolio this year, I did observe that our trade alerts moved the markets more than they did for other trades. But it still wasn’t a guaranteed event. Members who traded at the close, or alternatively the close of the next trading day, got better prices than our portfolios 25% of the time! The most striking example was our swap from OXLC to ECC on June 1. We sold OXLC at $4.19 in our portfolios, and it closed at $4.14 that day. The next day it closed at $4.67 (+11.5% vs. our portfolio price) and the day after that, at $4.82 (+15.0%)! I know from personal experiences that it’s always the missed opportunities that sting more, but you can see that even for the OXLC/ECC pair where prices for some reason moved much more than usual, it’s not always in favor of our portfolios (contrary to some of our members’ assertions!).

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2. Amount of alpha generated dwarfs trade alert slippage

Thirdly, and most importantly, the level of alphas that we’re generating dwarfs the magnitudes of the slippages that come from trade alert price movements. Take a look at the below comparison of the performance of our rotation strategy vs. buy-and-hold. Our rotation strategy on our CLO equity position generated a price return (not including dividends) of +58.50% from the close of March 12 to date. Trading at the close each day of the trade alert (“at close”) lowered performance to +41.10%, while trading at the close of the next day (“T+1 close”) was slightly better with a +44.13% return over the sane period. These are large slippages to be sure (and as I noted above, larger than other positions for some reason or another), but look at how much better those results were compared to buy-and-holding either OXLC or ECC! In terms of share count increases, trading at the close would have increased OXLC’s share count by +94% over 3 months, while for trading at the next day’s close, the share count increase would have been +98% over the same time frame. Less than the +116% increase that our portfolio reported, but still a marvelous result.

We can also see how the rotation strategy (even with the slippage) still crushed SPY. Of course, the S&P 500 isn’t an appropriate benchmark for our portfolios, least of all for a CLO equity fund, it’s only included as a comparison given how much bad press CLOs have gotten recently (see this article for an excellent rebuttal).

The below chart tracks the return profiles for the different positions above. Interestingly we can see even following on a T+1 basis, the returns were very close to our actual portfolio results until the final set of trades.

Summary

I wish all rotation trades were this quick, and this easy! But alas, they are not. Usually such swap trades take months to play out, and even getting a +4% alpha on a single swap is already considered to be a very good result. Don’t let yourself be so spoiled by the larger successes that you fail to act on the smaller opportunities! A few % of alpha here and there, if done consistently over the long run, can make a substantial difference in the long run thanks to the magic of compounding. Nick illustrates this concept nicely for us here: Income Lab Ideas: Reinvesting And Swap Trades Have A Huge Impact On Your Portfolio.

Why do I consider even +4% alpha an excellent result? Consider that a balanced stock/bond portfolio has on average returned about +8% per year historically. Adding +4% on top of that would be like increasing returns by +50% for a typical position! And if you can do two +4% swaps in a position in a single year, that would basically mean doubling your return vs. buy-and-hold.

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Another way of framing this is to consider that getting an extra +4% alpha from a fund that yields ~8% is like gaining 6 months’ worth of distributions “for free”. I would take that in a heartbeat for sure!

Our rotation strategy can also be used by investors to compound their share counts in CEFs without reinvesting dividends, if they need it for living expenses. Of course you don’t get the “double compounding” of both rotation and dividend reinvestment, but it’s still better than just buy-and-hold where you don’t get any dividend growth unless it comes from raises from the underlying positions, which is relatively uncommon for CEFs by the nature of their structure.

When it comes down to it, that’s really what this strategy is about, trying to generate an extra layer of profits on top of buy-and-hold. We don’t pretend to know which way the markets are headed nor which sectors are going to outperform in the future. What this means is that while executing the strategy, our positions will still be subject to the ups and downs of the market or underlying sectors, whichever they may be.* And there is no guarantee that the rotation strategy would be able to make up for capital losses when the markets or the specific sectors are in serious decline.

(*It it also possible to run this strategy is a market-neutral fashion, by shorting the overvalued fund and buying the undervalued one, in order to extract the difference. But shorting is recommended for advanced investors only due to borrowing expenses and the risk of unlimited loss.)

Another risk of this kind of arbitrage strategy is that it is possible for the sold fund to get more expensive and the purchased fund to get cheaper, so you could be waiting a long time before the valuation difference reverts (possibly indefinitely). This is why the more similar two funds are, the less risky the act of swapping between them is.

In a nutshell: the rotation strategy is intended to add to a long-term income strategy, not to replace it. I know that some investors balk at any mention of trading, but hopefully you’ll see that no market timing is required at all. You’re still invested in your favorite funds or sectors, but just switching between different CEFs based on the valuation difference between pairs. The rotation strategy can make the difference between a loser and winner as illustrated here, or turn a winner into an even bigger winner like we’ve observed numerous times last year when times were better!

I do know that many of our members have been able to profit from our swap trades recently, but what would make me happiest is to hear of members (and readers) who have been able to execute these rotation trades independently of our portfolios!

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Disclosure: I am/we are long ECC. 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.



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