Current Price – $20.05
Expected Price – $19.20
Upside – 4%
Expiration timeframe – 1-2 weeks
This is a fairly simple and straightforward arbitrage idea. QQQX is a closed and fund that is mimicking Nasdaq 100 index and trying to juice up the returns by selling covered calls. Historically this fund has always traded at c. 5% discount to NAV – discount to NAV prevails mainly due to funds admin fees, which are levied on shareholders returns. You can see NAV vs share price comparison here and further details on the fund and its holdings in here. For some reason over the last 5 days this discount has suddenly narrowed to 0.82%.
I have not found any news that would warrant such a change. So my trade here is to short QQQX with expectation that discount will return to historical 5% in the upcoming week or two. To eliminate exposure to the underlying assets (Apple, Google, Microsoft, Facebook and etc), I am hedging with an equal dollar amount long position in PowerShares QQQ, which is an ETF tracking the same Nasdaq 100 index and has almost identical portfolio allocations as QQQX. With this hedge my main remaining exposure is to the NAV discount of QQQX. There is also somewhat more technical coverage of this trade on SA.
Risks
– QQQ is not a perfect hedge to QQQX – there are slight differences in portfolio allocations and on top of that QQQX is selling covered calls. So QQQX returns would theoretically be higher than the ones of QQQ in falling markets. So if the markets start to fall my trade might not work out. But still that does not explain why the discount to NAV has narrowed so significantly. – Current borrow fees for QQQX stand at 6% annually (in IB) and if the discount does not revert to historical 5% in short term, these borrow fees will weight heavily on expected arbitrage returns. I do not intend to hold this position for more than 1-2 weeks, so current borrow fees are not significant. If borrow fees start to rise, the position might need to be liquidated even earlier.
– There is a small probability that discount will narrow even further, but as it is already at only 0.82% there is not much space for further narrowing, and I do not expect QQQX to start trading at a premium to NAV (almost unheard of for CEFs, especially for index tracking ones). Even if management announces liquidation of the fund (have not heard anything in this direction), the current tiny discount would probably still prevail until we get closer to full liquidation date.
– I have not managed to find any explanation for the recent narrowing of the discount, so I might have missed some crucial detail.
the cost to borrow can be high. i was quoted around 6.7% annualized. If the trade only takes 1-2 weeks then shouldn’t matter, longer though and you start to run into real costs etc.
Agreed. One the risks I have indicated.
Borrow can also increase if this trades becomes too popular.
FYI, everyone: As of 8:45 AM central time Monday at IB, I’m getting a ‘borrow not available’ notice.
There was some borrow this morning (I managed to open position before the trading hours), but now it seems to be gone. It might re-appear later.
Borrow now available again on IB.
Yep. But the spread narrowed about 0.7%
I got sent a screenshot from Bloomberg (thank you Will) which shows longer QQQX share price vs. NAV history (on cefconnect.com it is available only from Dec 2014). Apparently, there have been few periods (usually not longer than single quarter) where QQQX traded at a premium to NAV.
http://www.specialsituationinvestments.com/?attachment_id=1209
I believe that investors are far more educated about CEFs today than they were few years ago and therefore I do not think premium valuation is as likely as before. But time will tell. In any case it does not seem that QQQX ever traded at a premium for longer than a quarter. And if borrow remains at 6% annually I am quite happy to hold on to this position for the whole quarter. Potential increase in borrow fees or forced buy-in are my main concerns here.
So far the discount has expanded by 1%.
Discount narrowed again to 0.36%. Borrow increased to 8% annually. Probably NASDAQ will need to start declining (has been on the upwards path since the election) for the discount to reverse back to historical levels. However, the hedge with QQQ seems to work very well and despite narrowing of the discount the position so far is in +1%. Still, I have closed out the trade, as my expectation was that the discount will revert to historical average within a few weeks. However, it seems that investor optimism on technology stocks continues to be undeservedly translated into high demand for QQQX. This cycle might take longer to revert (as happened in couple of instances previously – see my comment above). With increased borrow costs the the expected upside of this trade was reduced and thus my reason to close it out.
In my previous comment, I mentioned that NASDAQ will probably need to start declining for the discount to return to historical levels. Well it started declining over the last week, but the discount so far has turned into premium of 2.3%. Historically, the highest premiums ever on QQQX were at 5% and these levels reached only on couple of days during 2013 and 2014. So we are very close to record highs. I do not believe this situation is sustainable and this might be good time to reenter the hedged position. The only problem is that borrow is really tight with 9.4% borrow fees.
Interesting that so called inefficiency is last for such a long time. I could not find any news that justifies the recent fund’s behavior. Any thoughts?
The same inefficiency lasted for the the whole quarter back in 2013 and 2014. Now it goes on for 1.5 months. Not sure what are the reasons behind such market behavior, but tight borrow definitely adds to that. I would mostly attribute this to irrational investor behavior, who buy QQQX disregarding the fact that QQQ provides the same exposure at far lower management fees.
It seems that we are witnessing new levels of insanity or just completely missed the point on this one. DT, are you still in the position and did you change the investment thesis? Thank you
Indeed, QQQX trades at 4% premium to NAV currently.
As per my comment on the 19th of Feb, I have closed out this trade and have not reentered it due to expensive borrow. Market irrationality with regards to QQQX is likely to persist as long as investors remain bullish on technology stocks (i.e. NASDAQ listed companies).