Proceedings of the 2009 IEEE Systems and Information
4
Engineering Design Symposium, University of Virginia,
Charlottesville, VA, USA, April 24, 2009
Financial Systems Analysis:
Opening the Future to Closed-End Funds
Kevin P. LaPorta, Zachary D. Shapiro, Ginger M. Davis, Michael J. Ledwith, Mark E. Paddrik
Abstract— This paper investigates a systematic quantitative
investment strategy utilizing closed-end funds (CEFs). CEFs are
advantageous to investors because they can be traded at a
discount from their net asset value (NAV), as opposed to mutual
funds which are traded at their exact NAV. The authors seek to
explore different methods for taking advantage of this discount.
They developed a program that exploits arbitrage opportunities
from the fluctuating discount by utilizing a dynamic moving
average and standard deviation. The program also fits an
autoregressive integrated moving average (ARIMA) time series
model to the data and attempts to predict the next price point.
Using all of this information, the program decides to buy, sell,
or hold a current position.
Investors make many decisions using emotions and other
biases that lead to the market mispricing a given stock or fund.
Throughout the history of the stock market, and emphasized by
the 2008 through 2009 economic crisis, brokers have been
unable to correctly assess the risk in a trading decision.
Automating the trading process through systematic quantitative
methods removes the human element from the process by
adding consistency to investing. In 1980, Thomas Herzfeld
published groundbreaking research on CEFs; they are still a
relatively small market and there is potential for more research
and discovery in this field. The aim of this research is to develop
an algorithm that will find above average returns while not
accepting above average risk.
I. INTRODUCTION
T ODAY’S global financial markets are extremely
complex and more volatile than ever before, making
investment decisions difficult due to the lack of confidence
regarding market stability. The decision making process to
buy and sell stocks can incorporate approaches from either a
qualitative, quantitative, or combined approach strategy. The
Manuscript received April 6, 2009. This work was supported in full by
Jon Simonds and the University of Virginia’s Department of Systems and
Information Engineering.
K. P. LaPorta is a student at the University of Virginia’s Department of
Systems and Information Engineering, Charlottesville, VA 22904 USA (e-
mail: kpl4n@virginia.edu).
Z. D. Shapiro is a student at the University of Virginia’s Department of
Systems and Information Engineering, Charlottesville, VA 22904 USA (e-
mail: zds2h@virginia.edu).
G.M Davis is with the Department of Systems and Information
Engineering, University of Virginia, Charlottesville, VA 22904 USA (e-
mail: gingerdavis@virginia.edu).
M. J. Ledwith is with the Graduate Department of Systems and
Information Engineering, University of Virginia, Charlottesville, VA 22904
USA (e-mail: mjl5w@virginia.edu).
Mark E. Paddrik is with the Graduate Department of Systems and
Information Engineering, University of Virginia, Charlottesville, VA 22904
USA (e-mail: mp3ua@virginia.edu).
1-4244-4532-5/©2009 IEEE 223
FPM2Env.Eco.
qualitative approach focuses on current news for a particular
company or fund, while a quantitative approach utilizes a
combination of historical trends and current data to make an
investment decision. This project focuses on creating a new
quantitative investment strategy for the United States
financial markets. The strategy was implemented using S-
Plus to automatically buy and sell funds according to the
trading strategy. Previous financial failures have led to large
amounts of criticism toward these purely quantitative
strategies. This project has drawn inspiration from these
historical attempts and created a back-tested automated
program that will be applicable to investors of all experience
levels. Additionally, this project has aimed to find the most
efficient and productive investment strategy based on risk
preferences and capital resources.
The specific investment strategy used focuses on closed-
end fund (CEF) analysis. A CEF is an investment company
that offers a portfolio of investment vehicles (primarily
including bonds or stocks), which is very similar to open-end
funds more commonly known as mutual funds. The project
used statistics, probability, and general financial analytics to
perform each analysis.
This specific strategy has also been developed to be
included in a portfolio of other investment strategies. Each of
the strategies will be implemented within analytics software
that uses a risk and money management system to allocate
resources appropriately. The overarching program will be
designed to determine the most efficient method to invest
according to a user’s risk preference. For example, if a stock
investment strategy was used, then the risk management
system might focus more on technology stocks than others if
the user is more risk seeking as technology stocks have
historically been more volatile. The system will then
distribute appropriate quantities of capital to each technology
stock individually. This paper will deal specifically with the
CEF strategy, and not the risk or money management
aspects.
CEFs are purchased, managed, and behave in a much
different way than most other investment types. A CEF has a
limited number of shares that are sold in a secondary market.
Because of this reason, among others, the shares are
commonly said to be selling at a discount or premium based
on their current share price compared to their net asset value
(value of all capital/securities minus expenses and liabilities
all divided by the number of shares outstanding) [1]. CEFs
also distribute dividends to each investor as well as possibly
the overall capital gains of the fund at the end of year in
order to avoid taxation on these gains.
 The CEF strategy developed through this study has
focused on two methods to earn a profit from investing. The
first was to work directly with the discount or premium of
the CEF, which is the difference between the share price of
the CEF and its respective net asset value (NAV) all divided
by the NAV. The larger the discount of a CEF, the more
attractive it is as an investment as it is expected to eventually
normalize (or have a smaller discount) over the long term
and thus increase in value. This strategy has been derived
from Thomas Herzfeld’s method of CEF analysis [1].
Herzfeld is a leading expert CEF trader and publishes a
newsletter of recommendations to buy or sell CEF on a
weekly basis. The strategy has automated this analytic
approach to identify positive buying or selling signals for the
investing program. The second approach was to create a time
series trend of a given CEF’s discount/premium in order to
predict the discount for the next day. This required
automated time series model fitting to each CEF, to
determine if the fund was a plausible buy or sell given the
trading decision parameters. The authors explored the
arbitrage opportunities using these two methods.
A. Problem Significance/Motivation
With any trading strategy, the main motivation is to
develop a technique that will earn above average returns
without assuming above average risk. This idea directly
contradicts the Efficient Market Hypothesis (EMH), as
discussed by Burton Malkiel, Eugene Fama, and many other
famous economists [2], [3]. Supporters of EMH believe that
the market accurately reflects the values of each stock, and
any stock not priced at its NAV will be exploited by
arbitrageurs and therefore return to its fundamental value.
This program attempts to consistently exploit the arbitrage
opportunities.
CEFs are a puzzle that economists have been trying to
solve for many years. In direct contradiction to EMH, they
are traded at a discount that can vary greatly from their net
asset value. Many economists use closed-end funds to argue
for an irrational consumer, which implies the potential for
arbitrage opportunities. This project attempts to support the
debate against EMH.
II. RELATED RESEARCH
A. Explanations for the Discount
Some economists have postulated that the discount exists
due to the high fees associated with managing a CEF. Using
empirical data, Malkiel found that there is no evidence that
discounts are correlated with management fees [4]. Also,
management fees are fairly stable, while the discount varies
greatly over time. Lee, Shleifer, and Thaler conclude that
agency costs cannot explain the discount [5].
Economists have also postulated that discounts exist
because of the miscalculation of the NAV. Lee, Shleifer, and
Thaler argue that “when funds are open-ended the price rises
to net asset value. If restricted holdings were overvalued, the
1-4244-4532-5/©2009 IEEE
net asset value should instead drop down to the price” [5].
This discount may exist because of capital gains taxation,
which is borne by shareholders. This means if you buy the
fund today and it realizes a gain tomorrow, you are liable for
the tax even though you have not earned any profit. Malkiel
calculated that this could not explain a discount greater than
6%, which leaves those discounts insufficiently explained
[2]. However, Brickley, Manaster, and Shallheim use
empirical evidence to find that a CEF’s discount is positively
correlated with the amount of unrealized capital losses, in
direct contradiction of Malkiels’ findings [6].
Lee, Shleifer, and Thaler offer another explanation of the
discount: investor sentiment. They find that “discounts on
closed end funds narrow when small stocks do well, as
would be expected if closed end funds were subject to the
same sentiment as small stocks” [5].
It is quite possible that the discount occurs due in large
part to all of these factors as well as others. The reason for
the discount is still hotly debated with no singular
explanation widely accepted. This mystery allows for the
possibility of earning superior returns.
B. Advantages and Disadvantages of an Automated
Trading Program
Automated trading programs have many advantages over
manual ones. While some traders are tempted to lose
discipline and break their own trading rules, a program will
not. Also, recent studies have found a negative correlation
between successful trading behavior and emotional reactivity
[7]. An automated program has no emotion and is more
likely to have “successful trading behavior.”
There are also distinct disadvantages to automated
programs. They are unable to take in dynamic qualitative
data such as press releases about a certain stock. Also, if
market conditions have changed that make the strategy
unprofitable, it will continue trading for a loss.
III. METHODOLOGY
A. Data Collection
The data were collected from Yahoo! Finance and
exported into an Excel spreadsheet, which was then imported
into S-Plus. The variables that were used include:
1.) Fund Name: the fund’s stock ticker label.
2.) Share Price: the market price for a single share of the
fund.
3.) Net Asset Value: the net asset value of all the equities
in the fund.
4.) Date: the date cataloguing the price of the fund.
5.) Dividend: the amount of dividend paid out.
6.) Dividend Date: the date at which the dividends were
paid out.
The discount is calculated by finding the percentage
difference between the share price and the net asset value
224
using the following equation:
Discount = Share Price – Net Asset Value
Net Asset Value
The authors selected funds with the greatest amount of
assets as well as a sufficient amount of historical data. After
finding the top twenty CEFs with the greatest amount of
assets, only eleven funds had sufficient data. From most
capital to least, these funds include: AllianceBernstein
Income Fund, Inc. (ACG), Nuveen Municipal Value Fund
represents a buy opportunity and when it goes above the sell
line (red), it represents a sell opportunity. The blue line
represents the moving average of the discount. The program
determines whether to buy, sell, or hold based on these
opportunities.
The program also calculates the dividends earned from
holding the funds. The dividend amount is added to the total
capital and used when calculating the annualized returns.
Closed-End Fund Analysis:
Discount vs. Time

0.02
Inc. (NUV), Eaton Vance Limited Duration Income Fund
(EVV), Nuveen Insured Municipal Opportunity Fund Inc.

0.00
(NIO), Templeton Global Income Fund, Inc. (GIM), Nuveen

-0.02
Performance Plus Municipal Fund, Inc. (NPP), Nuveen

-0.04
Discount (%)
Premium Income Municipal Fund Inc. (NPI), Blackrock

-0.06
MuniYield Insured Fund, Inc. (MYI), Gabelli Equity Trust

-0.08
(GAB), MFS Intermediate Income Trust (MIN), and Eaton

-0.10
Vance Tax Advantaged Dividend Income Fund (EVT). The
authors used four years of data, from November 3rd, 2003

-0.12
until November 2nd, 2007, to generate results.

-0.14
B. System Design Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2004 2005 2006 2007
The strategy was programmed using the statistical analysis Days

tool S-Plus. The program uses a series of tests to determine Fig. 2. The moving average of the discount of the Eaton Vance
whether to buy, sell, or hold a given stock. Fig. 1 outlines the Tax-Advantaged Dividend Income Fund (EVT) using a moving
average length of 15 and one multiple of the standard deviation.
architecture of our program.
As seen in Fig. 1, the program first takes in the required The program also plots the share price of the fund over
data from the Yahoo! Finance database. Next the program time, which is shown in Fig. 3. This allows the programmers
calculates a moving average and the standard deviation of to determine the general trend of the fund, which may help
the discount for an individual fund. The length of the moving explain the returns of the strategy.
average was varied using 5, 10, 15, 30, 45, and 60 days. It
then creates buy and sell lines by subtracting or adding a
multiple of the standard deviation to the mean. The buy and
sell lines were varied by multiples of the standard deviation,
including 0.5, 1.0, 1.5, and 2.0. After that, it creates the plot
shown in Fig. 2 combining all of the components. When the
discount (black) goes below the buy line (green), it

Fig. 1. The system architecture of the program.

1-4244-4532-5/©2009 IEEE 225

 TABLE I
Closed-End Fund Analysis: TRADING STRATEGY RESULTS
Share Price vs. Time
Prediction Buy and Hold 95% CI of Moving
CEF Return (%) Average Return (%)
30

Accuracy (%)
ACG 49.4 7.97 (6.66, 7.16)
28

NUV 45.8 5.33 (6.72, 7.33)

EVV 48.6 4.83 (5.62, 6.11)
26

NIO 47.4 1.98 (0.69, 1.45)

Share Price ($)

GIM 45.7 8.65 (11.39, 12.69)

NPP 49.0 4.18 (1.32, 2.15)
24

NPI 49.4 4.32 (3.14, 4.00)

MYI 52.7 2.94 (2.31, 3.08)
22

GAB 47.4 15.55 (11.19, 12.09)

MIN 48.2 2.42 (4.52, 5.02)
20

EVT 52.6 16.36 (17.89, 19.19)

18

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2004 2005 2006 2007
Days The average prediction accuracy was 48.7%. This is not
Fig. 3. The share price of the Eaton Vance Tax-Advantaged
Dividend Income Fund (EVT) over four years. much better than a coin flip, so it did not help create a
profitable strategy. These findings support similar studies
The second principal component of the program is the about the accuracy of ARIMA models using time series
creation of a time series model. The program attempts to fit financial data [8].
seventy different time series autoregressive integrated The moving average trading strategy was back-tested on a
moving average (ARIMA) models to the past thirty days data static set of data that included four years of information
to predict the next day’s price. The authors tested models about eleven different CEFs. A sample of the results can be
using orders of autoregressive models (AR) from 0 to 5 seen in Fig. 4. Using a moving average length of 15 days and
against orders of moving average models (MA) 0 to 5. They one multiple of the standard deviation, the trading strategy
used two different time x-axis (time and time squared) and produced an annualized return of 14.9% for four years with
took the difference of each model as each was non- the EVT fund.
stationary. They excluded the one model of 0 AR versus 0
MA for both time parameters as it is a model that is
completely random. The program then selects an appropriate Closed-End Fund Analysis:
Total Assets vs. Time
ARIMA model by determining which model has the
17000

minimum Akaike information criterion (AIC) value.

16000

IV. RESULTS
15000

After extensive back-testing, the authors found that that

Total Assets ($)
14000

none of the ARIMA models made accurate predictions over

13000

a one-year horizon. The program created seventy ARIMA

12000

models for each of the eleven CEFs, and then chose the
11000

model that best fit the data. The authors compared the
predicted values to the actual values and determined whether
10000

the predicted point was greater or less than the actual point.
9000

Next, they calculated the percentage of occurrences the

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
model accurately predicted the direction the discount would 2004 2005
Days
2006 2007

move. The results for the eleven funds are shown in Table 1.
Fig. 4. The trend of the Eaton Vance Tax-Advantaged Dividend
Income Fund EVT asset portfolio over time using a moving
average length of 15 days and one multiple of the standard
deviation.

The authors tested the trading strategy on all eleven closed

end funds, varying the moving average length and standard
deviation. For moving average length, the values of 5, 10,
15, 30, 45, and 60 days were used. For multiples of the
standard deviation, the values of 0.5, 1.0, 1.5, and 2.0 were
used. All combinations these values were tested to find the
optimal result. After averaging the annualized returns of the

1-4244-4532-5/©2009 IEEE 226

eleven funds, the results are plotted in Fig. 5. It can clearly
be seen that the 5, 10, and 15 day moving averages produce
better results than the 30, 45, and 60 day moving average for
all levels of standard deviation. Because of this, the authors
averaged the returns over all levels of standard deviation for
only the 5, 10, and 15 day moving averages and produced a
95% confidence interval seen in Table 1. Comparing the
returns of a buy and hold strategy, the program produced
better returns for five of the funds, worse returns for five of
the funds, and statistically similar returns for one fund. The
average returns for the buy and hold strategy was 6.77%,
which lies within the average 95% confidence interval of
(6.50%, 7.30%). Thus the strategy was unable to earn above
average returns.
strategy ideal for being implemented in a greater portfolio of
strategies. When the capital is sitting idle, as recommended
by the program, it should be utilized by other strategies to
make more money. Used in this way, the strategy could be
more profitable. Thus this program is ideally designed for
the Financial Systems Capstone project at the University of
Virginia, which aims to create a program that optimally
manages many trading strategies. This overarching program
will contain money and risk management systems that will
determine that amount of capital to invest in each trading
strategy.
Closed-End Fund Analysis:
Cash/Capital vs. Time

16000
14000
Closed-End Fund Analysis:

12000
Rate of Returns

10000
Cash ($)
0.08

8000
6000
Annual Rate of Return (%)

0.06

Moving Average:

4000
5 Day = Black
10 Day = Blue 2000
15 Day = Red
30 Day = Green
0.04

45 Day = Purple
60 Day = Yellow
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2004 2005 2006 2007
Days
0.02

Fig. 6. The trend of cash holdings over time using the Eaton Vance
Tax-Advantaged Dividend Income Fund (EVT) with a moving
average of 15 and a standard deviation of 1.
0.0

0.5 1.0 1.5 2.0

Based on the results, the program works better with
Multiples of Standard Deviations
smaller moving average lengths and standard deviations.
Fig. 5. The trend of average annualized returns varying the
standard deviation and moving average length.
There is a point where the returns start decreasing even as
the moving average length decreases, and a future project
V. CONCLUSION could find the optimal combination of moving average length
Looking at Fig. 5, it can be seen that the 5, 10, and 15 day and standard deviations using continuous levels of moving
moving averages produced the best results over all levels of average lengths and standard deviations instead of discrete
standard deviation, and thus are dominant strategies over 30, ones.
45, and 60 day moving averages. The program appears to be The ARIMA models were not good predictors, but a
most profitable when the share price remains fairly constant future project could explore using generalized autoregressive
over the long term, but has volatility in the short term. It conditional heteroskedasticity (GARCH) models to make
implements an automated contrarian strategy that assumes more accurate predictions. The benefit of using a GARCH
mean reversion over the long run. The program will buy model is that it provides a dynamic estimate of the volatility
when the stock is low, but if the stock continues to fall, the of the time series data and weighs recent events more so than
program will assume more buy opportunities and continue to past events to make a prediction of the next point [8]. The
buy. In a bear market, like the US markets in the end of ARIMA models assumed a constant variance estimate.
2008, this is a disastrous strategy. One way to counteract this Research has shown that financial data displays non-constant
possibly fatal flaw could be to use dynamic buy and sell lines volatility, so the GARCH models could provide more
that move with the trend of the share price. If the share price accurate estimates given the different assumptions between
is decreasing over time, then the buy and sell lines should ARIMA and GARCH [9]. A more profitable strategy could
shift downward in relation to the moving average to deter be found using these accurate predictions of both the future
overbuying. This would help mitigate the risk of consistently price of the CEF or an estimate of the volatility. One
buying as a stock decreases for long periods of time. possible strategy the authors considered was that if the
The program also has large periods of time when no predicted value was lower than the current value, and the
capital is being utilized as seen in Fig. 6. This makes the current value was below the buy line, the program would

1-4244-4532-5/©2009 IEEE 227

refrain from buying. This would prevent the program from
buying shares when the fund is still decreasing and assist in
buying at the lowest point. The same would occur in
opposite case where the price is still rising to allow the
program to sell at the highest point.
This program did not account for transaction costs nor the
risk associated with each strategy. Taking these into account,
the buy and hold strategy is superior. This program was
unable to add evidence against EMH, but that does not make
EMH true. There is, however, still hope for developing a
method to take advantage of possible CEF discount arbitrage
opportunities through other methods of time series analysis.

ACKNOWLEDGMENT
The authors wish to thank Jon Simonds and the
Algorithms Research Corporation for the help with research
materials and other support. They would also like to thank
their teammates on the Financial Systems Analysis Capstone
team, Thaddeus Darden, Margaret Ferrenz, and Christopher
Klann, for their assistance in editing the paper and
generating ideas.

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