Closed-end funds can be both a thrilling source of profit, with a double-edged sword attached – they offer huge risks in terms of massive volatility and drawdowns. Many investors find it challenging to remain profitable by reducing their exposure during market drawdowns. As such, there is a real impelling need for a more strategic approach to close-end funds that do not only maximize returns but also reduce risks.
Although they do have a lot of potential for money, closed-end funds (CEFs) are often overlooked in today’s investment scenario. But making smart plays with these funds cannot be merely a buy-and-hold strategy. Rather, people have been looking for smarter methods, that too, on the data-driven approach, which allows the investor to capitalize on the inefficiency in the marketplace-the distribution between market price and the net asset value of the fund.
Finally, enter a systematic trading strategy based on the daily differences between the price of a closed-end fund and its NAV. We can apply this trading strategy that assumes a momentum approach through technical indicators like the Relative Strength Index (RSI). This will drastically decrease the time spent in the market and minimize drawdowns to give more returns overall. The article will address this strategy by elaborating much on the back-testing results for the fund with the ticker code ETG.
What is a Closed-End Fund?
A closed-end fund, in simple terms, is an investment fund that starts off raising capital with a lump sum by way of an IPO and then lists on an exchange. Unlike open-end funds, CEFs do not continuously issue new shares, nor do they redeem outstanding ones. Their prices can vary far more significantly than NAV compared with open-end funds, thus offering a lot more allure for sophisticated investors.
Key Concepts
- NAV: The sum of a mutual fund’s assets minus its liabilities, divided by the number of outstanding shares.
- Market Price: The prevailing current market price at which the fund shares are trading on the stock market.
- Discount/Premium: A fund trading at a lower level than NAV (discount) or higher level than NAV (premium).
The Trading Strategy Explained
This strategy can be credited to the core relationship between the market price of the fund and its NAV. We use the technical analysis 2-day RSI of the price/NAV ratio to signal our entry and exit points.
Step-by-Step Trading Rules
- Long Position: If the 2-day RSI of the price/NAV ratio falls below 10, the fund is likely to be oversold and hence a good buying opportunity. We go long at close of that day
- Sell Indication: If the 2-day RSI crosses above 60, it is a sign that the fund is more than overbought, so that is good sell time. We exit the position at close.
Example with ETG
Our test case has the ticker code ETG. From the backtesting procedure, we made 212 trades with a stunning average profit of 48%. Notice also that we spent fewer days in the market than traditional buy-and-hold strategies and could thereby reduce exposure to volatility.
Backtesting Results
To prove any trading strategy, backtesting plays the most pivotal role. In this scenario, we had the task of running a considerable period of time behind the performance of the ETG fund.
Important Observations
- Total Trades: 212
- Average Gain: 48%
- Time in Market: Lower as compared to that of traditional strategies, which, therefore, resulted in higher drawdowns.
All these metrics represent the efficacy of the strategy. It brings not only high profitability but also vulnerability to the market vagaries for the investor.
Risk Management
A successful trading strategy isn’t complete without a sound risk management framework. Here’s how we sidestep risks in this strategy:
Stop-Loss Orders
Setting stop-loss orders ensures that losses are capped hence one is from the shock of any unexpected fall of the markets. For this strategy, a stop-loss would be placed at a given percentage bellow the entry price.
Position Sizing
Sizing positions appropriately will help one put a tight lid on risk and prevent capitalization of big loses. For example, the allocation of a specific percentage of a portfolio to every trade might ensure a balance.
Diversification
Although such a strategy can pay off in great sums when focusing on one single fund, such as ETG, spending this over a few CEFs will reduce the risk and produce even greater returns overall.
Key Advantages of the Strategy
- Minimum Drawdown : The drawdown is highly reduced due to less time spent in the market.
- High Returns : The average gain of 48% shows how worthwhile this strategy can be.
- Technical Basis: RSI helps ensure that trade decisions are made from a systematic and objective basis without room to allow sentiment to influence decisions.
Conclusion
The closed-end fund strategy outlined here is an innovative approach that outlines the kinds of risk and reward balanced in a single investment. In that regard, this strategy relies on the exploitation of differences between market prices and NAVs using the 2-day RSI to navigate the complexity in the CEF. The backtested results for ETG do support the idea that this strategy not only reduces time spent in the market but also maximizes returns.
Such a strategy would be pretty useful in today’s volatile investment climate, as it would give investors an important edge to achieve their financial goals with very less exposure to market-related risks. Having adopted this strategy might just be what you need in order to shift your focus towards the closed-end funds-from one of more risk to higher reward.
Implement this structured approach to better resilience and profitability in your investment portfolio. Ready to improve investment techniques in the pursuit of a smarter closed-end fund strategy?