The strong capital gains over the last few months in the CEF market are unlikely to be repeated. This means that to generate alpha income investors will need to rely more on alpha generation strategies. One such popular strategy is dividend capture. There are two reasons why the CEF population may be potentially attractive for dividend capture strategies. First, the CEF market is relatively inefficient in large part owing to its small size which means it does not attract a lot of smart institutional money. And secondly, the CEF population looks like an attractive target because of the tendency to pay larger dividends and do so monthly.
A dividend capture strategy is an income-focused short-term trading strategy designed to hold securities only for long enough to capture their dividends. At its most basic the investor purchases the shares prior to the ex-dividend date and sell the shares on or after this date. There is no reason to hold the security till its record or pay date.
The key question for investors pursuing a dividend capture strategy is what the ex-dividend date of a given fund is. This date can vary month to month and is typically announced by the fund in a release or on its website prior to the fact. For example, this is what the PIMCO release looks like. Aggregator sites like CEFConnect also publish these dates.
Source: PR Newswire
When thinking about executing the dividend capture strategy there are a number of considerations. First is the technical buying and selling pressure from other investors who are pursuing the strategy. The selling pressure is likely to be the highest on the ex-dividend date and should subside in subsequent days. Stacked against this is the market risk element. The longer the investor holds the fund out of the ex-div date the less technical selling pressure there is likely to be but the more market risk the investor takes on from random variability in the fund’s price. And the third element is the dividend accrual which works in the investor’s advantage through time. The longer the investor holds the fund the more its price should be supported through dividend accrual. However, the longer this period is the more the strategy begins to look like the traditional buy-and-hold.
To illustrate how this strategy might work we look at the simplest version of buying at the closing price the day before the ex-dividend date and selling at the closing price on the ex-dividend date. Obviously, being able to transact exactly at the closing price is operationally far from guaranteed but this strategy gives us a base case to see if there is something there. Let’s take the large, liquid and popular fund PIMCO Dynamic Credit and Mortgage Income Fund (PCI) as an example.
The chart below shows the combination of dividend amounts (blue bars) and the change in the fund’s price between the ex-div close and the prior day’s close. As expected we see a positive dividend and a variable but often offsetting move in the opposite direction in the fund’s price.
Source: Systematic Income
The success of the strategy depends on whether the running sum of the blue and orange bars is positive. The chart below sums up the bars for each month.
Source: Systematic Income
If we look over the last 5 years the median monthly return for PCI of this strategy was 0.04% and the mean was -0.01%. In annualized terms this is 0.5% and -0.15%. That doesn’t look particularly impressive – let’s see if we have better luck in the broader CEF market. If we run this stategy on the broader CEF market over the same 5-year period for funds with a longer than 3-year track record and at least 100k average daily volume we get an average annualized return of -1.3%.
So, this tells us that when this strategy is applied over the entire CEF market over the last 5 years for monthly-paying funds it doesn’t seem to work. So we have two options here, one is to change the strategy operationally i.e. don’t buy/sell on the close on the ex-dividend date and the date prior. The second option is to apply the strategy only to a subset of funds.
On the operational side we can make a simple tweak of selling at a different time than the close. If we sell at the open on the ex-div date then we get to an annualized mean return of 1.2% – still unimpressive but better than selling at the close. The trouble here, of course, is that selling at the open is far from guaranteed – though this was also true of selling at the close. The improved performance likely has to do with increased selling pressure through the day.
Taking a further conceptual leap and selling at the high on the ex-div date raises the median annualized return to 7.7%. Now obviously the high price of the security on the day can only be known in retrospect and is not something we can build a strategy around. What it does tell us, however, is that the high price does tend to be significantly higher than either the open or the close and that using limit orders to get out of the position during the day may make sense. The actual distance of the limit order from the open can be gauged from the historic open-to-high daily variability of a given fund.
The other question of this strategy is how should we annualize the results. So far we have been annualizing assuming we trade only a single fund once a month. If we use 21 funds (one for each business day of the month) and a close-to-open strategy then we get to an annualized figure of about 39%. This looks much more compelling though the close-to-close return is still negative which suggests that the limited liquidity at the open and the downward trend from the open to the close will limit the actual returns of the strategy.
Now let’s address the second strategy tweak – if we can choose a subset of funds that perform better than the broader population.
Source: Systematic Income
The best-performing of these funds appears to be the Alpine Global Premier Properties Fund (AWP). Its annualized average return is 2.95% and its median return is 0.87%. It does look like the average is skewed by a few good months during the recovery. This is possibly due to luck and creates a bias in the results as the market has been very volatile. Outside of this period the performance does not look overly compelling.
Source: Systematic Income
Teasing out which funds perform best just due to luck would most likely require excluding March and April of this year from the analysis although this can start looking like overfitting very quickly.
CLO Equity CEFs
The CLO equity CEFs appear particularly good candidates for the strategy given their large dividends. However, the average monthly return of the three funds is not compelling.
Source: Systematic Income
The recent track record across all three funds is quite poor which is telling of the timing risk involved in the strategy, however, even prior to this period the returns do not look obviously strong.
Source: Systematic Income
One interesting question to ask is can we tell whether investors are actually pursuing dividend capture strategies in CEFs? One way we may be able to gauge it is by looking at the seasonality of day-of-month returns. If we see technical buying pressure before the ex-dividend date and technical selling pressure on and after the ex-dividend date then this will be indicative of investors putting additional pressure on shares around these times.
Let’s take a look at the PIMCO taxable funds which are high-paying and liquid to potentially attract dividend capture interest. The typical ex-dividend dates of the taxable PIMCO funds have tended to be in the second week of the month and are highlighted in the chart below. It is likely not a coincidence that the first week of the month has tended to see strong returns and the second week the weakest returns owing possibly to the technical pressure from investors pursuing the dividend capture strategy. The chart also suggests that the opposite of the dividend capture strategy may in fact work best such as if the holding period is limited to the last and first weeks of the month.
Source: Systematic Income
Moves in prices are in part driven by moves in NAV which add a bit of noise to the analysis. Arguably, a cleaner way to look at this is to strip out the additional impact of NAV changes and just look at the seasonality of discount changes. When we do this the picture is similar but a bit more suggestive that investors are in fact pursuing dividend capture strategies.
Source: Systematic Income
We had a further look at the day-of-month seasonality across hundreds of CEFs (all available on the service in pdf format) and find clear evidence that investors are pursuing dividend capture strategies across higher-distribution funds. The evidence is strongest for funds with the highest distribution rates which makes a lot of sense. For example, the pair of Cornerstone funds which boast distribution rates around 20% have an unmistakable pattern of discount widening on or shortly after ex-dividend dates. Total price returns are also negative around these dates suggesting that the simple dividend capture strategy discussed above is unlikely to work in these funds.
This suggests that investors looking to add capital into these higher distribution-rate funds may want to do so soon after the ex-dividend dates when selling pressure has tended to be at its peak. Tactical investor may want to try their hand at the contrarian dividend capture strategy which would involve buying on or shortly after the ex-dividend dates and selling in the subsequent week.
Takeaways
A dividend capture strategy sounds promising for the CEF market which boasts securities with both high distribution rates and high frequency of distribution payments. However, we find that in aggregate the naive strategy of buying and selling funds around the ex-dividend dates does not appear to work. That said, there is some evidence that selling opportunistically prior to the close on the ex-dividend date as well as focusing on certain funds rather than the overall population may lead to excess returns. Finally, we also find evidence that dividend strategies are being pursued in the CEF market, particularly in the higher-yielding funds. Because discounts tend to widen on and after ex-dividend dates across the higher-yielding fund population investors looking to time their entry into these funds should focus on these dates.
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