Closed-end funds offer individual investors benefits that would otherwise be difficult to find, says Maury Fertig. Today, he zeroes in on a fund using covered calls, and another specializing in fixed income.
Kate Stalter: Today I’m speaking with Maury Fertig, Chief Investment Officer at Relative Value Partners.
Maury, you specialized in closed-end funds, and that’s an area that many of our listeners may not be too familiar with. So give us an overview of your investing strategy, and what individual investors should know about.
Maury Fertig: Well, let’s start with the basics of a closed-end fund. A closed-end fund is a mutual fund to start with, and it trades on the New York Stock Exchange, much like an ETF throughout the day. But unlike an ETF, it can trade at a significant discount or premium to the net asset value, or the value of the underlying assets.
That discount to NAV is really determined by a variety of factors, including the overall market sentiment, the structure of the fund, the asset class it’s in, and the type of distribution or dividend policy that the underlying fund has.
The United States has about 600 funds. About half of them are in the municipal area, but many of them are in other parts of the taxable bond area, and there are many equity funds as well.
Kate Stalter: Within those categories, where do you specialize?
Maury Fertig: Well, we tend to go where we think the best opportunities are. There was a time a few years ago when we had a fairly sizable position in muni-bond funds, but those funds have traded up tremendously, and we don’t see quite the same value that we did perhaps a few years ago.
Right now, the best values in the closed-end fund arena lie within several equity funds, so we tend to be focused more there right now. But that really depends on what’s happening in the market and the overall investor sentiment.
We tend to go to the areas that are a little bit more out of favor, where we see an opportunity for a number of things. An opportunity to make money from the underlying net asset value of the investment; to also realize some income during our holding period; and also finally, where we see a depressed discount. That is, to buy a fund at a deeply depressed discount of let’s say, 13% to 15%, where we think we can see this fund trade closer to its net asset value. So it gives us a little more bang for our buck.
Kate Stalter: Let me ask you briefly about how your investment vehicle is structured. Is it a fund of funds? Is it separately managed account, or something else?
Maury Fertig: Well, we are a bit unusual in the space we’re in, because we are separately managed accounts. We have a little over $600 million in assets. We have about 500 individual accounts.
So it’s very labor intensive…but unlike a fund structure, everybody has complete ownership of their assets, and we merely access it with limited trading authority.
There’s that comfort and also transparency. They know exactly what we’re doing in the portfolios. I think that just adds another layer of comfort for clients.
Kate Stalter: And Maury, can you say a little bit about some of the holdings right now that you do like?
Maury Fertig: Yeah. I guess there are a few areas in particular that we like. We like to go for situations where we think there is a catalyst to really compress the discount, but I think first and foremost, we have to like the underlying asset class.
Our favorite area right now is what you call covered-call funds. There are about 25 funds, these are equity funds that buy large-cap, dividend-paying stocks, and they write call options, at or slightly out-of-the-money to generate ongoing income for the portfolio.
The strategy over time has beat the S&P 500 (SPY) on an unmanaged basis, so there is some validity to the strategy. You don’t capture as much in a rallying market, but on the other hand, you don’t lose as much in a market that goes down.
When we got to this fall, the covered-call sector, in particular, got battered. Retail investors dumped these funds over concerns about the overall equity market, and concerns about the maintenance of the dividends. Right now there are a handful of funds that are still trading at double-digit discounts and offering double-digit yields that have a very likely ability to actually return 20% all-in, in 2012, in a scenario where the market chops around.
I can speak to some of the economics of that on a couple of particular holdings. One of our favorites right now is called the Eaton Vance Tax Managed Diversified Equity Income Fund (ETY). There are several funds like this.
Some of the specifics about this fund: It’s a fairly large fund, with about $1.7 billion in assets. It specializes in covered-call writing. It has a distribution rate—that is, a dividend yield—of about 12.1%, and it pays that dividend quarterly. It also is trading at a 13.5% discount to its net asset value.
The interesting thing about a fund like this: in 2010, this fund traded at net asset value. So the fund is currently trading at $9.50, and the net asset value is about $11. In a normal time, this fund has had the ability to trade at net asset value.
There had been some concerns over the dividend. The dividend was cut a little over a year ago. There were certainly concerns over that, and it’s certainly a possibility, but I don’t think it would prevent me from making investment like this.
Some of the largest holdings in this fund are names like Apple (AAPL), Qualcomm (QCOM), Exxon (XOM), and Coca-Cola (KO), and they merely use these stocks and write call options against them to generate income.
In addition, for an individual investor in a non-IRA or non-retirement account, there is some significant tax benefit, because the premium income actually goes towards writing down the basis, so that 12% is not treated as ordinary income.
Kate Stalter: And you had another one you were going to mention?
Maury Fertig: This is in the fixed-income area. There are not many we like in fixed income right now, but our favorite fund in fixed income is called the Nuveen Multi Strategy Income Fund (JQC).
What we like about this fund is, it’s in the leveraged loan space. This is part of the market. Just to go through the capital structure and bonds, you obviously have what you would consider the safest in terms of principal repayment, government bonds, and then you move down to investment-grade corporate bonds, which offer more yield. Then, at the bottom of the spectrum, you have high-yield bonds.
But between high yield and investment-grade bonds are what they call leveraged loans. These are secured financings that banks make, generally it might be in an LBO [leveraged buyout] or some type of situation where a company is leveraged. Most of them are floating-rate debt, but they are definitely higher credit quality than high yield.
So there are about a dozen…closed-end funds that specialize in buying these loans. It’s very diversified, and it’s something that individual investors generally cannot buy, these individuals loans, so a fund is the real way to go. You need the diversification, and it’s hard to have the expertise to buy the individual loans.
The nice things about these funds are, all of the loans are generally floating-rate. So if interest rates were to rise, you don’t have the risk of losing principal in a higher rate environment. You’re looking at yields at around 5% to 7%.
The average fund is trading, though, at a discount of only about 1.5%. This fund is trading at a 9.3% discount, and the reason is, it formerly was an equity and preferred fund, and Nuveen announced in the fall their intention to convert this fund into a leveraged loan fund. They started that process a few weeks ago.
It also pays a yield, a distribution yield of over 9% on a quarterly basis, and we think that as this transformation takes place within this fund, you can get some capital appreciation, plus make a nice return from your dividend as well.
There are not a lot of fixed-income funds right now that are attractive, but I think this one is the exception.
Kate Stalter: Now, a couple of the things you mentioned, Maury, made me think of another question—something individual investors are often concerned about—which is expense ratios. Particularly with regard to closed-end funds, what should people be aware of?
Maury Fertig: Well, I would look at funds that have what I call an outsized management fee, which is a fee that might be significantly greater than what you might find in a mutual fund. Most of the large fund complexes—BlackRock, Nuveen, Eaton Vance—their fund expenses are generally in line with other mutual funds.
One of the attractions when you buy a fund at a deep discount, I almost think about it as: If I can buy a fund at a 10% discount and there’s a 1% management fee, in a sense I’m getting that management fee paid for ten years, because of the discount associated with the purchase.
But I look at funds that have a normal expense ratio…nothing out of the ordinary. There are some funds that have expense ratios in excess of 2%. One good way to look that up for an individual investor is a Web site called CEFConnect.com. That lists all of the management fees.