When diversifying your portfolio, fund correlation may be an important consideration, says John Cole Scott, CIO, CEF Advisors.

 

Investius

We’re talking with John Cole Scott of CEF Advisors. He’s very interested in the topic of diversification, and he’s recently done some research that pertains to correlation. John, tell us what you’ve discovered.

 

John Cole Scott, CIO, CEF Advisors

Well, we looked at correlation figures for the 12 major closed-end fund sectors in a 10-year period that ends December 31, 2015. We found two really interesting things. First off, the sectors of convertible bond funds, senior loan funds and high-yield bond funds…

 

While they generally cover different companies and obviously different structures, where they have change in rates and change in pricing, they have a correlation of 93 and change and 98 and change on a 10-year basis. So while you diversify by manager or maybe underlying position, the sentiment of diversification is not there… Be mindful of that when you build that into your portfolio.

 

On the other hand, we looked at sectors that are well-known by investors in the closed-end fund space. Like munis, and preferreds, and REITs and MLP funds. And they offer a lot of diversification against other asset classes.

 

Investius

Talk a little more about correlation. It may not be a familiar term for a lot of people, so what exactly are we saying when we say it’s correlated. It’s not cause and effect, right?

 

Scott

No, it’s not. And there are certain periods of time where a lot of markets can be highly correlated. And again, we even studied, if you want to get more minutiae, the differences pre-oil fall versus post… Some differences, but a 10-year horizon does ease that out. The correlation means in a given quarterly period, the movement of the NAV versus another sector’s NAV. So this is not the market price or discount movements. This is the manager’s result, which we feel is the most important long-term for investors. And it gives you a chance where… if you were diversified, part of your portfolio should always be annoying you, because it’s not going the right direction. If it’s always going the same direction, you’re not diversified.

 

So we think we build your portfolio where closed-end funds are a major piece or a minor piece. You’ve got to start first with asset allocation, and these are the building blocks that build the pie chart that makes up your closed-end fund piece. Remember, closed-end funds… the NAV is what’s important. The market prices are volatile. That may feel unsettling sometimes, but that’s your chance to get better entry and exit points, which provides a patient, diligent advisor/investor, in my opinion, a more sophisticated outcome.