The Leveraged Income And Alpha Strategy: Part 2

Includes: DBL, PDI
by: Michael Fabian

In my opinion, closed end fund investing is still a corner of the market that an investor can get out in terms of performance, as much as they put in by way of research and analysis. Not all areas of investing are like that anymore. The equity markets used to be that way, but it's getting tougher now. A diligent stock-picker could handily outperform the S&P 500 over long periods of time. The legendary mutual fund manager Peter Lynch comes to mind, along with his famous quote:

Average investors can become experts in their own field and can pick winning stocks as effectively as Wall Street professionals by doing just a little research.

Circumstances have seemingly changed now with the whole "Risk on/Risk off" cliche', where even a seasoned veteran can have a well thought out and executed idea run over by the macro currents of the market. The same thing can happen in CEFs, and that's why investors need to be extra vigilant. However, In my experience, CEFs are still an asset class where meaningful alpha can be generated by more than just purchasing an undervalued fund, but also through superior ongoing management and investment philosophy.

Management and Strategy

As I described in Part 1 of this series entitled, The Leveraged Income And Alpha Strategy: Part 1, there are a series of weightings in which I use to decipher the attractiveness of a CEF. Two factors I hold in very high regard are the superiority of the management team in comparison to their peers, as well as their expertise in the strategy they are implementing. An example of two popular funds I currently own with similar portfolio strategies but different risk management philosophies are the DoubleLine Opportunistic Credit Fund (NYSE:DBL), managed by Jeffrey Gundlach, and the PIMCO Dynamic Income Fund (NYSE:PDI), managed by Dan Ivascyn.

Their strategies are geared toward investing in the same sector of the bond market, with the bulk of their portfolios invested in Non-Agency MBS. Both managers have long histories of successfully posturing their funds in this specialized area to capitalize on the fundamental improvement in housing. They are masters at seeking out undervalued credits in relation to the collateral the loans are backed by, then exploiting these dislocations for the benefit of income and capital appreciation. Based on my evaluation of their open end fund counterparts, performance history, and risk management, these are two of the best fixed income specialists you could place your hard earned dollars with.

Taking a closer look at risk management, each respective team has a unique way of approaching the inherent risks of the bond market. Gundlach typically favors a more conservative strategy of cash and high-quality Agency MBS as a safeguard against the credit exposure within his portfolio. There is also no use of leverage currently in effect for DBL. Conversely, Ivascyn takes a more aggressive stance, and is more apt to leave positions in force and use swaps to hedge credit or interest rate volatility. PDI also carries a leverage ratio of 48.01%, and in addition, has exposure to high yield corporate, as well as emerging market bonds. Although there is no correct answer to this equation, it is important to understand exactly how the management team will react to changes in the credit and interest rate cycle. By looking at a one year comparison of both price and NAV performance for each fund, there are some striking differences.

Although PDI has outperformed DBL largely due to leverage and credit exposure, they are both excellent vehicles depending on how you plan to taper the exposure to Non Agency MBS within your portfolio, and the amount of risk you feel comfortable with. The way I see it, you can control the risk to each manager's respective "house view" by simply controlling your position size, and then using the trading strategies I pointed out in Part 1 to develop your entry and exit plan. I believe at this time PDI presents a better investment opportunity than DBL because the fund is currently trading below its average premium/discount for the last year. In addition, PDI has a higher UNII, and PIMCO funds rarely trade at discounts due to the large amount of investor interest they garner, as well as their low cost of borrowing.

Not that it is a major sticking point for me, but like the investments I select for the clients of my firm, I make it a policy of owning the very same investments in my own account. In other words, I eat my own cooking, and it appears Dan Ivascyn feels the same way about his management, since he currently holds over 250,000 shares of PDI according to the most recent SEC form 4 filings.

Watch List

After you have sought out, researched, and evaluated the teams and strategies you have comfort level with, the next step is compiling a shortlist of all the funds they manage that you would like to own in the future. The reasoning behind this is that you want to channel your energy to analyzing say 15-20 funds vs trying to keep close tabs on over a 100; its just not realistic or effective. The composition of my watchlist is spread out amongst the various sectors of the bond market, that way I have a "go to" fund for each area, so that if I want exposure to say floating-rate senior loans, I know exactly where to allocate. A fund that I recently added to my watchlist that I don't have a position in now, but want to in the future, is the newly offered DoubleLine Income Solutions Fund [DSL].

I know based on prior research, I can trust the team will post superior performance, but I'm waiting, because I don't have enough detail on the underlying strategy or the percentage of the assets they are going to allocate to the sectors mentioned in the prospectus. I'm also letting the IPO lockouts expire to see if the price will come down a bit closer to its NAV before initiating a starter position. If history is any guide, I could be proven wrong by waiting, since DBL never got close to par during its early days. However, with DSL's gargantuan 2.3 Billion dollar offering, making it one of the largest IPOs in CEF history, there will be plenty of volume, so it will be an easy fund to get a hold of. Creating a list then evaluating it daily will allow you to jump on opportunities more readily as they present themselves. Furthermore the work you put into planning will eventually turn up by way of superior performance in the future.

Part 3

In the final part of this series detailing the basics of my CEF strategy, I would like to offer my thoughts on integrating CEFs into your existing portfolio approach. A "CEF only" portfolio is not a realistic strategy for most investors, so I will discuss integrating them as a "sleeve" to work in concert with your existing positions. Success in any strategy comes down to developing a plan and then implementing it decisively.

Disclosure: I am long DBL, PDI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Fabian Capital Management, and/or its clients may hold positions in the ETFs or mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.