Understanding Tax-Loss Selling In Closed-End Funds: The Target CEFs of 2013

Tax-loss selling is not a phenomenon secluded to the closed-end fund structure of investment vehicles. 

However, due to a few CEF specific characteristics, it is the best place for investors to benefit from the historical desire to reduce your current year’s taxes by harvesting losses.

1.      CEF IPOs provide a good number of CEFs every year that usually trade at significant discounts to their IPO price six to twelve months after they are launched.

2.      CEFs are diversified and professionally managed vs. buying common stock in one company. This should help to protect against the downside risk of the portfolio’s net asset value declining more than the general market.   

3.      There are usually similar closed-end funds to swap into to maintain exposure and to avoid the Internal Revenue Service’s (IRS) tax wash sale rules.

4.      Discounts widening on a relative basis is a documented common occurrence for year-end investors. Better performing CEFs hold their relative discounts noticeably better than poor performing CEFs.

5.      Many of these fund also have a typical discount narrowing in early January.

This is called the January effect as the discounts typically snap back towards regular levels in early January, once investors are in a new tax year.

How did CEFA conduct its research? We looked in our weekly Universe data for both the December 6, 2013 and December 7, 2012 week-end data. As there were essentially 600 funds each year, we grouped them into the top 200, middle 200 and bottom 200  based solely on YTD Market price TR data. We then averaged various data on the funds from both years to look for the impact of tax loss selling. A summary is provided below.

We selected 200 funds per group and averaged their data from two market years (2012 and 2013) in which different funds did well or did poorly. In 2012 bond funds had yet another strong year while equity-oriented closed-end funds saw only moderate growth. On the other hand, in 2013 bond funds have done very poorly while most equity-oriented closed-end funds have performed very well.

By both taking a sample size of 200 funds and using two very different market performing years, we are reasonably confident that the data is not impacted by fund sponsor, sector or other unrelated trends. Of course, each year as we can add another year of data the results will be more powerful. It should also be noted that the tax-loss harvesting is unlikely to be over for a few weeks. It typically starts the week before Thanksgiving, which was abnormally late this year, and ends in the last seven to ten days of December.

The following are some guidelines on tax-loss selling or the January Effect. It usually starts the last week of November and discounts bounce, back up or narrow around the end of December or the first 10 days of January.

Widening discounts are one way to see this event, as discounts go wider during this period compared to other months of the year. However, we find it easier to find this phenomenon by looking at Relative Discounts and Relative Z-Stats as together they will show a more complete picture of the funds that are acting worse than their historical selves and their peers when reacting to recent market trends.

The trends tend to be the most pronounced where there is the most liquidity or broad-based taxable ownership of a fund. This often includes the specialty equity and municipal bond groupings.

The other group to look in for this opportunity is the failed IPOs from late fourth quarter of the previous year (of 2012 for this season) through the second quarter of the current year (through June 30, 2013 for this season). The premise is that all who own shares of one of these funds, if it is selling below its initial IPO price, have a short-term loss.  The reason we like to end the targeted funds on this list at mid-year, is that most funds have green shoe support (the over allotment) for about 45 days and this first round of useful fund updates comes after the 6 month mark.

It can be noted that none of the above 24 closed-end funds (as of December 6, 2013) trade above their IPO market price. The tax loss pressures should be greatest when the current price vs. IPO is under 75% (last column), as this marks a non-total return loss of 25% or more. It would not include dividends, but they are inconsequential when looking to take a short-term loss to off-set already realized short-term gains.

Happy Hunting!