Rule 1: Do not look simply at published discounts to determine valuation.
T.S. Eliot wrote that "April is the cruellest (sic) month." While that may be true for poets and academics, for closed-end fund investors this year, late May and early June were the cruelest. Indeed, the fright that overtook some investors in fixed-income CEFs is quite apparent by looking at average discounts. Taxable fixed-income CEFs averaged a 0.12% discount at the end of April, a 3.55% discount at the end of May, and an average 3.63% discount at the end of June. Investors in national municipal bond CEFs saw the average discount widen from 0.87% at the end of April to 5.03% at May's finish, before settling back to 2.73% at the end of June. For state municipal CEFs, the average discounts were, respectively, 1.49%, 5.48%, and 3.07%. As reflected in these numbers, the markets have been on quite the emotional roller coaster ever since Federal Reserve Chairman Ben Bernanke mentioned "tapering" the Quantitative Easing program.
It was in the midst of the recent market turmoil that I found myself moderating a panel of opportunistic CEF investors at the Morningstar Investment Conference. Patrick Galley of RiverNorth Capital and portfolio manager of, among others, RiverNorth Core Opportunity RNCOX, John Cole Scott of Closed-End Fund Advisors, and Rob Shaker of Shaker Financial Services joined me on the dais to discuss CEFs. All three are "opportunistic" in the sense that they patiently wait for abnormally wide discounts to emerge, buy such shares, and sell when they believe the discount has tightened significantly. I'm paraphrasing, but below I'll delve a bit into their strategies. Needless to say, given what was going on in the markets, much of our time was spent discussing how investors can better use discounts to take advantage of market sell-offs.
Buy and Hold?
While all three of these professional investors are more trader than long-term investor, Shaker had a really poignant, concise point for buy-and-hold investors. "The important thing to remember is, if you are going to buy and hold, you need to remain faithful to that idea." Pointing to the widening discounts that were ongoing at the time, he stated "this is not the time to sell. This is the time to buy and to hold what you already own because, before you bought, you knew this kind of volatility was possible."
Shaker is a guy who speaks his mind, which is one of the reasons I was so pleased to invite him onto the panel. Truer words about investing in CEFs could not be spoken. CEF investors need to know what they're buying and how leverage will magnify their fund's volatility. But, unfortunately, time and again, in market sell-offs we see the discounts widen out significantly and quickly. I'm quite sure that this will always happen. Discounts and premiums for closed-end funds are nothing but a barometer of CEF investors' collective greed and fear; in fact, it is well-known that the average discount for all closed-end funds is highly correlated to the S&P 500 Volatility Index, or VIX, more popularly known as "the fear index."
Shaker's points are true. Investors should know, before they buy shares, what they're getting into. The sad fact is that most investors don't do their homework and rush to sell their shares when the first dark cloud appears on the horizon. Forgetting that most CEFs are akin to micro-cap stocks with very thin trading volumes, they race for the exits, sending their CEF share price down faster than the underlying NAV decline. The discount widening engenders more fear, which leads to more selling, until the vicious cycle eventually wears itself out. While such timid investors are busy dumping shares, the three men on my panel are on the other end, buying shares at bargain-bin prices. Hopefully, reader, you will do the same. Buying when there is panic all around has been a solid long-term investment strategy at least since the Rothschilds employed it in the early 1800s.
Buy when there are market dislocations and discounts widen significantly, knowing full well that there will be future market downturns, and hold on through those downturns. That's CEF investment wisdom right there.
Discerning When a Discount Is Enticing
The offices of RiverNorth Capital are only a few blocks from Morningstar's Chicago headquarters. Unsurprisingly, I met Galley very soon after reviving Morningstar's CEF research presence in 2010. Since then, I've tried countless times to learn the secret ingredient that he and co-portfolio manager Stephen O'Neill employ in choosing CEFs for their portfolio. When you're the manager of a long-term 5-star rated mutual fund, you hold your cards close to your chest. So, of course, I'm never going to succeed in my endeavor. Galley, though, was very forthcoming to our audience, as were Scott and Shaker.
Their approaches can be combined and paraphrased as follows. They don't look at published discounts and premiums. They don't care that a fund is trading at an 8% discount. As Galley said, "we don't just buy the funds with the largest discounts because there's probably a reason why a fund has a 15% discount."
What all three do care about are relative discounts. They care that a fund is trading at an 8% discount when it usually trades at a 2% premium, the widest discount it has had in the past few years is 9%, and every other CEF with a similarly invested underlying portfolio is trading at a 1% discount. In this second scenario, they are most likely kicking the tires on the fund if they aren't already buyers. Rob explained that at Shaker Financial, their investment strategy can be called "discount capture": they buy a fund trading at an artificially wide 8% discount (in my theoretical example here); investor fear subsides; the discount narrows; he sells, thereby capturing 2-3 percentage points of performance from the discount narrowing, on top of the likely recovery in the underlying net asset values.
What of premiums? Lo and behold, all three of these investors would be willing to invest in a CEF at a premium. The reason is that they look at the relative valuation. So, if a fund is currently trading at a 10% premium and typically trades at a 25% premium, this would be similar--on a relative basis--to a fund that typically trades at a 5% discount and is currently at a 20% discount. So, their opportunism isn't limited to only funds trading below net asset value.
If you listen to these guys long enough, you'll learn that they all share at least one highly valuable quality: patience. They don't decide to buy a fund because they have some extra cash lying around. They wait for what Shaker calls "carnage periods"--times in the market like we saw in late May and early June. Even then, they don't just jump in and buy any old CEF. They follow their processes of looking for CEFs with artificially wide relative discounts.
John Cole Scott is a well-known figure to many of you, as he is very active on the Morningstar CEF Discussion Board. It will therefore come as no surprise that his views on participating in CEF initial public offerings are very different than mine. But, for the panel, I wanted to bring this out in the open. After all, at a conference, contrasting opinions often fuel great discussion. What I didn't expect, though, were Galley's and Shaker's comments.
Scott stated that his firm has never invested in a CEF IPO. That's significant, because the firm has been around since 1989. It's not just the initial premium that has kept him and his father away from IPOs. The basic fact of the matter is that new funds do not have a track record, by definition. There's no record of how the fund has traded relative to its peer group or even itself. Therefore, their investment process precludes them from investing in IPOs.
Shaker followed up Scott's remarks by noting that Shaker Financial has also never participated in an IPO. His firm was founded in 1995. His reasoning, while similar to Scott's, is quite interesting. He said that they have found that during the end-of-the-year tax sell-off, you can usually pick up funds that had IPOs earlier in the year at least at a single-digit discount. He prefers to buy these fledgling funds during the tax sell-off and own them through the "January effect," when share prices and markets tend to rise. This, to me, exemplifies the patience and the opportunism that is required for successful investing using CEF discounts.
Galley admitted that he has invested in two IPOs since 2004. The only reason he bought shares was because, relative to similar funds, the IPO premiums were low. In other words, he bought shares at a roughly 5% premium expecting the premium to go even higher.
How to Get This Kind of Success
It was a great time to have a chat with three prominent CEF short-term investors. All three have recorded good to great total return performance by following their investment approaches over the years. You can click here to see the performance of RiverNorth Core Opportunities. Closed End Fund Advisors does not post the performance track record of their portfolios on their website (as far as I can discern), but they do have an edited transcript of our panel's discussion. Shaker Financial Services puts their performance right on their home page. You can see from the track records of Galley and Shaker, at least, that this investment approach to CEFs has worked well.
To have similar success, investors need to forgo the published discounts/premiums and focus instead on relative discounts/premiums. Patience and courage are also required. It's not easy or natural to sit tight and buy shares when everyone else in the room is frantically rushing to the exits. Whereas May was a cruel month for many CEF investors, the three guys on my panel in mid-June couldn't have been happier, having recently restocked their portfolios with bargain-priced CEFs.
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