This Panel was held at Morningstar's 25th Anniversary Investment Conference in Chicago on June 14, 2013. It was moderated by Mike Taggart, head of US closed-end fund research at Morningstar.
Taggart: On the panel with me today, I'm very pleased to have Rob Shaker of Shaker Financial, Patrick Galley from Rivernorth Capital. Patrick is a founder and portfolio manager at Rivernorth. They run several funds that have closed-end fund strategies in them and John Cole Scott, portfolio manager and EVP at Closed-End Fund Advisors (CEFA), a registered advisory firm that also offers a closed-end fund newsletter, which is available for free, on their website.
The question on most people's minds is quantitative easing and what happens to closed-end funds when interest rates start to rise. Are you concerned?
Galley: Yes. About two-thirds of the closed-end fund space or about 400 out of 600 closed-end funds that are out there are fixed income focused and oftentimes, those closed-end funds implement leverage in their capital structure so are interest rate sensitive investment vehicles and investors know that.
What's really interesting, unlike in 2004. Where it was really the short end of the yield curve that was moving up, presently it is the long end of the curve where interest rates are rising. That's actually a good environment for the CEF market. We're talking about the steepening of the yield curve, where the funds are borrowing in short-term, very low rates, and investing in the longer end of the curve.
With the recent move in interest rates, we've had a sentiment shift away from fixed income. You have a discount component in closed-end funds, not only is the net-asset value (NAV) going down presently, but now the discounts are widening quite a bit as well. For us, this is actually an opportunity as Rivernorth is an opportunistic investor in closed-end funds. We're buying when everybody is selling and the discounts are widening out and we're selling as everybody is buying in the discount scenario.
Scott: I would agree. We're not concerned yet about leverage at the fund level. What we're really thinking about presently is investor's sentiment about what that leverage means for CEFs, what duration means for the bond funds. I think there are some great values right now.
Shaker: CEFs are a great vehicle to be able to gauge what sentiment is doing and how sentiment is affecting market price. It's something that is very unique to closed-end funds and a great vehicle so that you can take opportunities as they present themselves.
Instead of being concerned with the rising interest rates, the focus should be on the effects of a steeper yield curve on the CEF's portfolio and that could be a positive effect. Where closed-end funds are today, we think it's definitely a better environment than it was a couple of weeks ago.
While we're on the topic of leverage, most closed-end funds do use leverage. Therefore, a lot of investors don't even consider closed-end funds because of the volatility that happens with the leverage. First you want to make sure you understand the leverage is there and you want to see how it affects the volatility.
I would say the leverage is important because you figure out how net investment income will be squeezed at some point but the trading of a CEFs market price is more important of a factor to understand than just the leverage effects on NAV.
When building your portfolio, instead of using a standard mutual fund - you can use a closed-end fund and that gives you the opportunity to have the extra variable, your knowledge of the NAV and the discount.
Taggart: How do you actually determine whether or not what a closed-end fund should go into your portfolio. How do you go about assessing the discount and other factors you might consider?
Shaker: At Shaker Financial, we manage several managed accounts with balanced portfolios. Instead of using ETFs or mutual funds, we use closed-end funds. What we do is called "discount capture". We try to fill an account with a closed-end funds that we believe are at artificially wide discounts. If we can then replace it later, once the discount it narrows, we can capture one or two discount points. We then can potentially replace it with a different fund that is now at a historically wide discount.
There are a lot of ways you can analyze a CEFs historical average discount. There's a lot of things that will move that but if you're patient and you have something, even as generic as a six-month average discount to help you get your entry point or your exit points. Knowing what that is, you'll be able to take opportunities from periods like now when fixed income seems to be artificial wide.
Taggart: I would just note that you guys don't invest in closed-end funds based simply on their published discounts?
Galley: For us, it's not just buying the deepest discounted closed-end funds because there's probably a reason on why something's trading at a 15% discount. We have ETFs or a sub-advisors to marry our closed-end fund strategy with. As discounts widening out, we sell ETFs, buy closed-end funds, as discounts narrow, sell closed-end funds, lock in that excess return and buy the ETF.
Scott: At CEFA, we have separately managed accounts with seven different investment models or objectives. We analyze a CEF using three main factors. One is what has been the one year net asset value total return vs. peer-funds and what is our anticipated trajectory based on our firm's view of the credit and equity markets.
Second, we then, look at the sustainability of the dividend. Is it reasonable? Is it maintainable? How does it look compared to its peers? Is it lower than normal, higher than normal. Third, we look at the discount that the fund is currently showing. We tend to focus on one-year Z-stats, the 90 day relative discounts and current peer-group comparable discounts.
Is it cheap? If it is cheap, why is it cheap? Is it because of a news item?, a change in the market? or just a bad manager or performance? If you can answer those questions, I think you have a much better forward-looking trajectory for a closed-end fund portfolio.
Taggart: Just to kind of sum up and one of the reasons that I really appreciate these guys work and why we asked them to be on the panel is because they really understand the point that serious closed-end fund investors don't simply buy a closed-end fund because it's trading at an 8% discount. If you buy a closed-end fund if it's trading at say an 8% discount, its historical average might be a 12% discount then you're buying it relatively expensive to what it normally trades.
The other thing, you all mentioned is that you keep an eye and do this quantitative stuff. By the way, they use a lot of quantitative screens as well. It's what they do day-to-day. There are a lot of people with closed-end funds who think that they're more of a trading vehicle and that they're not buying and hold. Are CEFs suitable for advisers to put into a client's portfolios as buy and hold investments?
Shaker: We don't buy and hold because what we're all about is tactical swapping as much as we can, as fast as we can. We're trying to get as much alpha generated as possible but that does not mean that it can't be used in a buy and hold situation. The important thing to remember, is if you are going to buy and hold, then you need to stay true to that concept.
If you didn't know, in the last week, after the tapering fears came out, fixed income closed-end funds got sold off dramatically. You had a generic widening of about 5% or 6% across the board for these CEFs. This "carnage period" in closed-end funds, is not the time to sell; that's the time to buy or hold on to what you bought because you knew this was possible.
CEFs are a good vehicle for buy and hold but you just have to remember where you bought it. Closed-end fund investors are buy and hold until they're not. They're buy and hold for the yield, for the income and it's great. Frankly, now we're even getting a higher yield because now that closed-end fund is sold off. The NAV sold off and in fact and sometimes it can be a double discount. You're getting very attractive asset classes at good prices and you're getting attractive market prices, meaning at discount to those net asset values.
Taggart: That's why a CEF investor should be a total return investor in closed-end funds and not just yield-based investors.
When people are selling off CEFs, selling their shares, stampeding through the exit, these are three of the guys who are standing on the other side taking the trade. If you're wondering about their performance, I think Patrick's five-star performance on the Rivernorth Core Opportunity Fund attests to the fact that over time, that strategy pays off. John, buy and hold?
Scott: If this conference had been a month ago, we'd be saying the discounts are relatively narrow, the bond fund returns had been strong, and for advisors to be protective on the downside for the CEFs they currently held. Well, that's not today's panel. It's the -5% discount average world we presently live in vs. a +2% to +3% premium. We could fall further, but based on the last five years, we're presently considered a relatively cheap place for CEFs. If you like the manager, you can then worry less about the volatility. If you have our resources maybe you trade off volatility actively, but you don't have to have this access to make money in a CEF.
Galley: When the volatility starts increasing, all of a sudden, those underlying assets start depreciating, premiums can become discounts. We find the IPO investors are the first ones to bail. You have closed-end funds that just went public a few short months ago. They were at 5% premium. Today, some of them are 5% to 10% discounts. Those investors are not very happy buying at IPO.
On a historical basis, Rivernorth has participated in two IPOs since 2004. We very rarely will participate in an IPO. The only reason we did is because we believe that the premium will actually go higher, when we compare it to other funds in the same asset class and also by the fund sponsor.
Taggart: Right now, there are five closed-end funds IPOs pending in the market. This year, we're on track to have the most IPOs in the closed-end fund space since 2011. John Cole Scott and I have very different views on the closed-end fund IPOs. John, can you just follow-up with Patrick on closed-end fund? Have you ever invested in a CEF IPO?
Scott: We never have. Part of that comes from our perspective of wanting to trade a close-end fund based on how it's traded against itself and its peer group. Also, knowing what type of securities it owns, what its undistributed net investment income (UNII) trend is looking like on the balance sheet for a bond fund, what its duration figure, etc. You simply can't do that with an IPO.
By definition, it's not just disliking the IPO because some IPOs do prove successful. We did a study from 1991 to present, we found 50 IPO CEFs that had tracking ETFs so we could try to net out much of the market exposure, not the leverage - but sector trends. For the average fund we found that if you wait about nine months, you get about a 7.8% alpha over the IPO price which is about 2.8% over the usual 5% load for closed-end fund IPO.
Our perspective on trading and our experience with the results have led us to generally avoid them. However, if nobody buys them on the IPO, then we can't trade them later.
Shaker: I've seen many people try to explain why a CEF has a discount and I think they all fail. The only thing I've ever seen proven it is that there's the "January effect". What we found is IPOs take that pressure specifically hard during this period. If you get an IPO, you can normally get them at a discount at the end of the year with a typical rebound the following January.
I know that potentially during the fourth quarter, if a CEF IPO'd at a 5 premium, it might be at a 3-4 discount, maybe even wider. We've never participated in a CEF IPO.
Galley: Getting back to the buy and hold. It is a risky proposition but we were looking specifically at other funds in that same asset class, other funds by that fund sponsor, where they were trading and compare it to a 5% premium and they are all higher. A reversion closer to those peers is what we are betting on.
Taggart: Advisors tell me that the most prevalent question they get is, "Is my dividend safe?" Well, we call it distribution rate at Morningstar. I would say most people buy closed-end funds for one of two reasons, one is the discount.
Secondly, for the income that they generate, closed-end funds typically generate two to three percentage points more in terms of the rate than similar funds in the same category. They do that through a couple of methods that we're going to have to discuss. So, John, closed-end fund, the higher relative income, is it worth the risk?
Scott: Well, first of all, a closed-end fund is a fixed capital product so the manager never has to worry about redemption pressures like in an open-end bond fund. A closed-end bond fund is an equity that derives its value from bonds. Taxable bond CEFs have a market price volatility about 40% higher than NAV and muni bond CEFs have a market price volatility about 350% higher than NAV volatility (at present). If you are trading, this volatility can be your friend.
If you look at what the portfolio is yielding, taking out the discounted or premium, and leverage - you can get a sense of what is has to occur in the fund to meet the distribution payment. If the manager needs to pay $0.10 per month, and that came to a 6.2% leverage adjusted net asset value yield - is it reasonable for the sector? What do peer funds show as comparison?
Galley: Closed-end fund investors, for whatever reason, some funds sell off 10 to 15% just because of a dividend cut. That shows you the irrationality of the investors, but it also shows you on why investors owned that closed-end fund. It was because of the yield and only the yield. They're completely yield focused and again, it goes back to being total return focused. You have to look at everything involved.
As a board member of that fund, you have to ask yourself, if I cut that dividend, this premium is probably going to evaporate and that loss could be catastrophic to investors. What's the bigger evil? Cut the dividend or just pay out return in capital. Sometimes, I think a board of a closed-end funds in a conundrum and that's why you do see return of capital and sometimes these premiums go higher and higher.
Taggart: Our studies internally show that of all the distributions made by all closed-end funds last year, 23% were comprised of return of capital and that could be what we consider to be constructive return of capital or destructive return of capital. Destructive is when you're getting your own money back.
Galley: I'm going to jump in. I don't view the return of capital as necessarily destructive. Unless you're maybe trading at a premium to your net asset value, and you're getting your money back at net asset value, that's not necessarily good. If you're trading at a discount and you're getting your money back, return of capital and it's at a discount, you're getting your money back at net asset value. To me, that's excess return no matter if the fund is losing assets.
Scott: When people talk about current funds at premiums that have never cut their dividend, I'd say, "Yeah, they've never cut their dividend till the day they announced it in the press release." If you're going to be in those funds, it might be worthwhile to have a stop point that you can live with that's enough below the normal trading volatility of that fund but protective of the premium completely going away.
Taggart: For us at Morningstar, fund family transparency, education around closed-end funds is very important. I believe that advisers, when they buy a fund they should be able to find that information without having to call the wholesaler on the fund.
Shaker: We haven't met a fund family that we've decided is too sketchy or too out of touch that we put them on any type of blacklist. In fact, we found in general, surprisingly … you can call these people. They have phone numbers and if you see something strange in annual report you can give them a call and say "What happened?" and they will often tell you.
Galley: Closed-end funds are 1940 Act registered investment companies, so they are like mutual funds from a reporting standpoint, they have to report at least on a quarterly basis their holdings. You do get that transparency at a minimum. We have analysts that are able to go through the quarterly reports and analyze what their holding, have they had any shifts, etcetera?
From our standpoint, we think most closed-end funds sponsors are giving us good transparency. They are posting more information on their website, sometimes monthly, sometimes even weekly, daily. We think we're getting quite a bit of transparency as far as being able to assess what's going on in the underlying portfolios and be able to tactically manage our exposure.
Scott: We find that many funds are very good. The only thing we often wish for is fresher data. When the funds give us fact sheets monthly with updated figures for the balance sheet, for different items, exposure, for state, for bond funds exposure, for duration, we love it because then we have a more recent window into where the fund could go. Sometimes the smaller funds, that only do a quarterly year, or sometimes only do report semiannually lead us to have stale data and we only will buy the fund at that point from a trading perspective not because we're comfortable with the dividend or past holdings.
Taggart: Why are there discounts and why are there premiums at all in closed-end fund?
Galley: There has been a lot of academia, research reports, white papers on why discounts? We live in an efficient market, correct? You have a security that's owned by retail investors. They buy and sell for irrational reasons a lot of times, but I will say it's the structure of the closed-end fund that's inefficient. It's not necessarily the investors.
Scott: To follow up on liquidity, about half of closed-end funds trade between $500K and $2.5M a day in average liquidity and that is not a lot of liquidity. The funds above that level ($2.5M+) are less inefficient, the fund is below that level (under $250K) - I don't know if any of us can regularly buy that unless we're an activist oriented approach with a long time line to get in or out if needed.
Galley: Today, you have different types of leverage, but really, the margin facility by brokerage firms or banks is probably one of the most prevalent out there and that gives them a lot of flexibility. What they don't have is the benefit of a lock up, meaning that they're typically 365 days of rolling credit. The bank has the ability to pull that leverage from them, but the reality is that very rarely happens. We find that to be pretty cost efficient leverage for the closed-end funds and pretty secure.
If that leverage went away, probably the dividend is going to get cut and investors are going to sell and it's going to go to a big discount, that's something we're waiting for to try to jump on that opportunity.
Taggart: One last sentence, advice to advisers and individual investors, where they're looking at close-end funds.
Scott: Stick to your plan. Track what you're doing. Tweak it over time. Hold the course.
Galley: Be total return-minded and opportunistic. Don't be all in closed-end funds all the time. Have dry powder to be able to buy more when everybody is going to the exits.
Shaker: Remember that part of your total return is the growth of the fund, plus or minus the discount capture or discount loss you take. Be mindful, discount matters. Make sure that you're at least following the news on the funds you have, because it can come off with something of a dividend cut, or some good news like manage distribution policy.
Taggart: Gentlemen, thank you very much for joining us today. Everybody thanks for joining us. Thank you.