Thu, 1 Aug 2013
The current environment is positive for CEF investors as more attractive discounts are coming to the surface, particularly with fixed-income vehicles, says RiverNorth's Patrick Galley.
Mike Taggart: Hi, I'm Mike Taggart, head of U.S. closed-end fund research at Morningstar. Investing in closed-end funds can be a rewarding, if complex, endeavor. As an institutional portfolio manager, Patrick Galley of RiverNorth Capital knows how to navigate the complexities of closed-end fund investing better than most. Patrick oversees $800 million of closed-end funds, and I'm happy to have him here with me today at Morningstars' Investment Conference.
Patrick, thanks for joining me.
Patrick Galley: Thanks for having me, Mike.
Taggart: Patrick, the question on probably every closed-end fund investor's mind right now is what's going on with the discounts. Obviously it's related to Fed chairman Ben Bernanke's comments in May about tapering the quantitative easing. Discounts have widened out significantly. What's your take on closed-end funds in this environment?
Galley: Closed-end funds are probably one of the best sentiment indicators out there because of the discount and premium associated with them. When there is greed in the marketplace, discounts are narrow. CEFs even trade at premiums; that's the environment we were in [in May]. [In mid-June] it's gone to fear, and discounts, specifically on the fixed-income side of the equation, have widened out quite drastically in the tune of 5% to 10% in some cases in just a short two weeks. We really think it's a fear-driven trade, meaning that fixed-income investors that were invested for yield only are now pushing out discounts as they sell their fixed-income closed-end funds and then lock in gains, which they actually still have from a total-return perspective.
Taggart: Do you think it's overdone? What's your outlook for what happens to closed-end funds, a year down the line as interest rates rise?
Galley: I think if you're looking at the discount, it's overdone because the discounts are that sentiment gauge. These are discounts that we haven't seen for quite some time. We are still in a world of low short-term rates, and we think that's pretty darn attractive for closed-end funds because if the Fed starts loosening the quantitative easing, it's the long end of the curve that's going to rise, which means we have a steepening of the yield curve. That's a positive environment for the closed-end fund space. You have more attractive discounts today, and you have a better carry trade for the closed-end funds on the fixed-income side.
Taggart: It sounds like you're pretty bullish?
Galley: We're excited about the environment we're in today.
Taggart: In your flagship portfolio, the RiverNorth Core Opportunity fund, which is unfortunately closed to new investors, it's a 5-star Morningstar-rated fund. But it's opportunistic, meaning that it's not necessarily buy-and-hold, that you're looking at discounts. In this kind of environment you must be having a field day. Can you just walk us through how you would figure out if a discount is warranted or unwarranted and your investment process of choosing a fund to go into your portfolio?
Galley: Sure. First and foremost, you have to be comfortable with the exposure that you're getting by investing in a closed-end fund. You can't just buy a closed-end fund just purely based off of the discount. You have to look at what the underlying exposure is, if it's leveraged, and how much volatility you are willing to take in that asset class.
If you're comfortable with that--for example, if you want municipal-bond exposure--you can buy municipal bonds today at 10% discounts in some cases. But that hasn't happened in a while. If you're comfortable with the net asset value exposure, the underlying assets, you'd then look at the discount. We look at the discount on a relative basis, meaning not on a just pure absolute basis, but where is the current discount relative to where it was trading [beforehand], to its peer group, and to the overall closed-end fund space.
Taggart: For instance, if municipals, which you just mentioned, had been trading at a 10% discount for the last year or the last three years, they wouldn't be so interesting because relative to where they've been trading, it's not anything special. But since they've been trading, even in some cases in the past months at premiums, now that they're trading all of a sudden at 10% discounts, this is when you're interested.
Galley: Exactly. You mentioned a word earlier on, "opportunistic." You have to be an opportunistic investor in closed-end funds. Have dry powder, be willing to buy more closed-end funds as the discount widens out, and put more capital to work. We utilize exchange-traded funds in our Core Opportunity fund. We sell ETFs and buy closed-end funds as discounts widen. As discounts narrow, we sell closed-end funds and buy ETFs. Therefore, you're locking in that excess return by tactically managing through that discount widening and narrowing.
Taggart: It's an interesting strategy for sure, and it's worked in your portfolios. You mentioned volatility, and the importance of looking at the underlying asset and getting comfortable with that. A lot of investors don't even look at closed-end funds because they think they're too risky. And yet, when I look at your portfolio, I see that there is risk in it--the RiverNorth Core Opportunity fund.
Over the last three years, Morningstar says that the fund has an above-average Morningstar Risk rating, but it also has an above-average return track, which means that you're compensating investors appropriately for the risk you're taking. How do you think about the risks of individual closed-end funds when you're adding them into your broader portfolio?
Galley: Again, it all goes back to the underlying assets, so you have to be focused on the portfolio construction. We're probably one of the most diversified mutual funds out there. We own 50 closed-end funds and various asset classes, but we do look through to the underlying exposure and also the leverage that we're getting from the closed-end funds. And we tactically manage that overall exposure on a day-to-day basis. From there, we're also monitoring and managing our overall closed-end fund risk because I think that discount risk is what scares a lot of investors away. That's what actually obviously excites us. We want to be buying when everybody is selling, and we're selling when everybody is buying. We're truly a contrarian in the marketplace.
Taggart: You mentioned diversification, do you think in your experience that with adding the closed-end funds together, is there a significant amount of portfolio diversification that you get? Because the individual closed-end funds have a lot of risk and volatility in them. Can you speak to that about the volatility of when you add them together and form a portfolio out of them?
Galley: Yes. The great thing about closed-end funds is you can virtually get any type of asset class. You can get equities. You can get fixed income. You can get Treasury bonds. You can get high yield. You can get any asset class that you want to exposure to. Some of those asset classes have negative correlation to each other. By constructing a portfolio smartly with closed-end funds, you actually can bring down your overall volatility, your overall risk, but not necessarily take away from your return. And then on top of it, if you trade the discount smartly and opportunistically, you can add alpha, or excess return, by trading the discounts, as well.
Taggart: Obviously the data support the fact that you've done that very well. It sounds like it's a very interesting environment for you. Thanks for taking the time out of your day to sit down and chat with us.
Galley: Thanks, Mike.
Taggart: For Morningstar, I'm Mike Taggart.