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How Fragile Is Your Fund?

We take a look at some practical rules of thumb for assessing a fund's risk profile (aside from volatility). 

Steven Pikelny, 02/08/2013

Last week we reviewed some key points of Nassim Nicholas Taleb's recent book Antifragile, in which he outlines three categories for assessing how systems are affected by volatility, uncertainty, randomness, and Black Swans.[1] Then on Tuesday, we looked at some specific examples in which some leveraged funds drastically underperformed their unleveraged closed-end fund peers. Because these funds were fragile, the magnitude of the underperformance was greater than historical volatility would have suggested. One key takeaway of this analysis is that, from a fund investor's point of view, it is much easier to avoid fragile funds than to attempt to predict Black Swans (they are, by definition, difficult or impossible to predict). But still, there is some gray area. With this in mind, let's look at some guidelines for detecting fund fragility.

Leverage
The simplest way to detect fragility is to conduct a quick scenario analysis. Looking at a leveraged fund, for example, shows that leverage increases fragility. Consider a fund with $100 million in net assets and $50 million in leverage, giving it a leverage ratio (total assets/net assets) of 1.50. Should asset prices decrease by 10%, net assets would fall 15% and the leverage ratio would increase to 1.59. Another 10% drop would cut net assets by about 16%, increasing the leverage ratio to 1.70. Now let's start over, but this time by increasing asset prices by 10%. Net assets are initially affected by the same magnitude (with an increase of 15%), but this also lowers the leverage ratio to 1.43. The next 10% increase in asset prices would only increase net assets by 14%. This relationship holds for all degrees of leverage, though the funds with leverage ratios close to 3.00 (PIMCO Strategic Global Government RCS, for example) are in a different ballpark than the ones with leverage ratios of 1.10.

While boilerplate characterizations often note that leverage magnifies both upside and downside, remember that the downside is magnified more so.

Fund Vehicles
As we explained last week, fund flows make open-end funds and exchange-traded funds more fragile, especially when dealing with less-liquid asset classes and crises where market liquidity vanishes. Sharp outflows can force the fund to sell assets into a falling or illiquid market, which can sometimes push asset prices down even further. Likewise, strong inflows can force the fund to buy more assets in an overvalued market. For fixed income, this can dilute returns as the fund buys lower-yielding assets. Investors should be particularly skeptical of open-end funds and ETFs that employ leverage. Even these vehicles rarely use leverage (and when they do, leverage ratios usually stay below 1.25), flows add an extra complication. Returning to our example of a fund with a leverage ratio of 1.50, let's say that the 15% decrease in net assets spooks investors, leading to a sharp outflow of 10% of the fund's assets. Although the outflow may not directly affect returns, the fund's leverage ratio now jumps up to about 1.65 (instead of 1.59). In extreme market drawdowns, such as in 2008, the fund may not be able to deleverage quickly enough to avoid the negative consequences. As more investors head toward the exits, outflows can then pick up momentum.

CEFs provide an attractive alternative to that scenario in many respects, as the closed capital structure takes fund flows out of the equation. Still, premiums and discounts make things a bit more interesting. Short-term investors might find this attractive, as betting on investor sentiment can provide some added capital appreciation, though it may be a turn-off for long-term investors. Nevertheless, long-term investors can protect their principal with some smart decisions. First, be willing to ride out short-term volatility and hold a fund through a market cycle--extenuating circumstances aside. Black Swans do occasionally hit CEFs, causing their discounts to blow out for reasons unrelated to the net asset value, but the risk of capital loss here is often limited. At best, this creates a temporary buying opportunity until share prices bounce back. At worst, the fund can always conduct a tender offer or liquidate the portfolio if a large discount mysteriously persists (for this scenario, stewardship is a major consideration).

Second, avoid funds trading at large premiums. As a rule of thumb, assume the entire premium will dissipate by the end of the year. If this is not acceptable, move on. For a stark example, look at PIMCO High Income Fund PHK. This fund is often a punching bag for bloggers, financial columnists, and Morningstar analysts, for good reason. The fund started 2012 at a nearly 70% premium but crashed down to roughly a 25% premium by year-end. Even though the fund had a NAV total return of 40.1% for the calendar year, its share price total return lost 1.8%. Some investors blame the media for "causing" the premium to collapse, but this misses the point that large premiums are inherently fragile.

Another rule of thumb: Never buy anything that can collapse on the negative opinion of a blog.

Portfolio Managers
Occasionally, funds will take highly concentrated positions in dubious high-risk assets, or position the portfolio for an all-or-nothing event. In these situations, do not blindly accept that the portfolio manager will be able to effectively time the market and unwind that position in the nick of time. Even the best managers can make forecasting errors. Take Cohen & Steers CNS, a fund company known as being stalwarts of real estate investment management. Even with this expertise, they concluded in the 2007 annual report for Cohen & Steers Quality Income Realty RQI: "...based on our view of market sentiment, real estate fundamentals and valuations, we see the potential for attractive total returns, barring an unforeseen and dramatic economic pullback." Six months later in the semiannual report, they stated: "We believe REITs, on the whole, are attractively valued, with many trading at compelling discounts (more than 20% in some cases) to their underlying net asset values, compared with their long-term average of a 5% premium to NAV." The fund then proceeded to drop 82% over the next 20 months.

Steven Pikelny is a closed-end fund analyst at Morningstar.
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