Most investors are familiar with the fact that most Closed-end Funds (CEFs) trade at a discount to Net Asset Value (NAV) and carry an above average dividend, but are unsure of how to profit from these variables.
There is also a relatively new investment product known as Leveraged Exchange Traded Funds (ETFs), which seek to double the daily returns of a specific index. There are leveraged ETF products for every general sector in the market as well as the broad indexes. There also are leveraged ETF products that move opposite to the underlying index.
An investor can utilize both of these products to generate income similar to that of a fixed income instrument, but this strategy has much less volatility. By implementing this strategy, an investor takes advantage of the above-average dividends that the Closed-end Funds provide and virtually eliminates the risk of the transaction using a leveraged ETF that moves in the opposite direction of the index that the CEFs follow.
The Closed-end Funds used in this analysis made investments in Real Estate Investment Trusts (REITs). The portfolio strategy is based off the investor purchasing a set amount of CEF REITs and simultaneously buying half that amount of the ProShares UltraShort Real Estate ETF (SRS). Below is a breakdown of the model portfolio (Please click on the picture for a pop-up of the portfolio in a much clearer format):
The Funds used in the portfolio are as follows:
SRS - Proshares UltraShort Real Estate ETF
SRQ - DWS RREEF Real Estate Fund
SRO - DWS RREEF Real Estate Fund II
NRO - Neuberger Berman Real Estate Securities Income Fund
RTU - Cohen & Steers REIT & Utility Income Fund
RQI - Cohen & Steers Quality Income Realty Fund
RMR - RMR Real Estate Fund
In this case, using the CEF REITs and ProShares UltraShort Real Estate ETF creates a portfolio that is market neutral and set up to make roughly 6.856% a year in dividend income. The portfolio also has the possibility of generating additional return by closing the gap of each fund’s discount to NAV, which currently averages 6.982% for the portfolio.The variability of the portfolio should be minimal because any market movement would have a negligible effect on the portfolio. However, there are some risks involved. One of the risks that could affect the portfolio’s health is the individual management of the closed-end funds and/or any changes to dividend policies. An additional risk is that the portfolio relies on an expectation that the leveraged ETF will double the overall movement of the index; but since the leveraged ETF is marketed to double the daily return, the compounding effect could be a significant factor in how much the investor profits from the portfolio.
The income factor makes this model portfolio extremely attractive, as does the opportunity to receive some capital gains from the movement of the Closed-end Funds towards their NAV. Though IRA accounts are usually long-only positions, this investment could work well in an account such as that. Furthermore, it would be advisable to perform this trade in a tax-free account, such as an IRA because the distributions made by the Closed-end Funds do not fall under the favorable dividend tax laws, since REITs are required to pay out 90% of their taxable income as distributions. If a trader chooses to perform this trade in a taxable account, then it would be worthwhile to hire a tax accountant to look at any tax consequences to this trade.
