A topic that sparks interest in the normally staid world of income investors is arbitrage – a concept typically reserved for high-flying trading operations of Bank proprietary desks and hedge funds.

We often come across posts that offer the following ideas:

  1. Buy cheap CEF A and sell short CEF B
  2. Buy cheap CEF A and sell short ETF B

Our first point on these trade ideas is a minor one – let’s not use the word arbitrage. An arbitrage implies risk-free profit within a certain period of time. An example is equity index arbitrage which trades the index (via futures) against the individual components. The CEF ideas listed above are relative-value pair trades – there is nothing “risk-free” about them.

Our second point is more important – operationally it is difficult to sell CEFs and ETFs short. There are two additional wrinkles: first, borrow rates can be on the order of 6-7% so waiting for the pair trade to perform can become painful and secondly, your short position can get bought in at any point without you being notified. If you have a different experience with a particular broker please comment below.

Our third point is that CEF markets can remain “inefficient” for a long time as mean reversion is far from guaranteed so the relative-value pickings are fairly slim, though we would be very happy to be proven wrong here.

One way we look at funds is as a substitution or a switch. For instance currently PZC is the most expensive Muni CEF on a discount basis with a premium of 23.9%. Our take is it is highly unlikely that PZC is able to generate that much alpha in order to justify such a premium. Instead, it is very vulnerable to a price drop in case of a dividend cut. More on this to come from us in the future.


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