Thu, 19 Sep 2013
Interest-rate fear is a good thing for the recently reopened RiverNorth/DoubleLine Strategic Income fund, says portfolio manager Patrick Galley, who discusses his comanagement with DoubleLine's Jeffrey Gundlach.
Mike Taggart: Hi. I'm Mike Taggart, head of U.S. closed-end fund research at Morningstar. With me today is Patrick Galley, portfolio manager at RiverNorth Capital Management. Patrick manages about $800 million in closed-end funds.
Patrick, thanks for joining me today.
Patrick Galley: Thanks, Mike.
Taggart: Patrick, you recently have reopened one of your funds that you comanage with Jeffrey Gundlach, the RiverNorth/DoubleLine Strategic Income Fund. It seems to me to be one of the most opportunistic funds out there. Can you talk to me a little bit just about the general investment objective?
Galley: The investment objective is to beat the Barclays Aggregate, predominantly on a risk-adjusted return basis. We're all about risk-adjusted returns at RiverNorth, so the most important objective to us is how much risk you take for incremental return.
Taggart: And how do you measure risk?
Galley: The volatility of the fund and the performance, and if sometimes we do have incremental volatility--but for that incremental volatility, we expect more return.
Taggart: One of the criticisms of the Barclays Aggregate is that it's heavily weighted with Treasuries. So isn't that kind of a little bit of a sandbagging of that index?
Galley: Well, you definitely want to have some type of benchmark that investors can measure you to, and we think the Barclays Aggregate is one of the best-known benchmarks out there. So that's what we chose, because it is a fixed-income-focused fund.
Taggart: My understanding of this fund is that it's essentially two sleeves [that are] very opportunistic. It's your sleeve with opportunistic closed-end fund investing and Jeffrey's sleeve with opportunistic fixed-income investing. Is that fair?
Galley: Yes, actually there [are] three sleeves. So DoubleLine is managing two sleeves. One is the core fixed-income strategy, that is Jeffrey's tactical Barclays Aggregate strategy and just general diversification across fixed-income. That's roughly 50% of the fund on a neutral basis. The other sleeve that DoubleLine is managing is an opportunistic income strategy that's similar to Jeffrey's hedge fund strategy, which is predominantly mortgage-backed securities--nonagency and agency mortgage-backed securities.
Then the third sleeve is managed by us at RiverNorth, and it is an opportunistic closed-end fund strategy, where we're opportunistically investing in closed-end funds when opportunities present themselves, i.e., discounts are widening out. So we'll take from the core fixed-income strategy as our dry powder and increase our closed-end fund sleeve as opportunities present themselves.
Taggart: It seems like this would explain the reopening. There are plenty of opportunities right now, it would seem, and listening to Jeffrey's calls, there are of plenty of opportunities for his opportunistic sleeve. Can you talk to me a little bit about how you decide the allocation decision across those three sleeves?
Galley: It is very opportunistic, and so given the opportunities in closed-end funds--the fear has increased in the closed-fund space, as we know, because of interest rates--discounts have widened out quite drastically. So just a short few months ago, most closed-end funds--fixed-income closed-end funds--traded at a premium to their net asset value. Today, most closed-end funds are trading at a discount to their net asset value and, in fact, only 13% of the time have they ever been wider than they are today on the fixed-income side of the equation on closed-end funds.
Taggart: So is it safe to say that three, four months ago there was less of an allocation in the fund toward closed-end funds than there is today?
Galley: Exactly. So just about four months ago, we were 17% closed-end fund exposure; today, we're over 30% closed-end fund exposure. Probably an upper limit to closed-end fund exposure in the fund will be around 50%, because [as] most investors know, extra volatility [comes] with closed-end funds. So we don't want to concentrate the portfolio all the way to closed-end funds, but 50% is more of an upper limit.
Taggart: Gets back to the risk-adjusted comments earlier.
Taggart: So what's the investment process? If you could just briefly go over it for the closed-end fund sleeve, and then if you could speak for Jeffrey, both of his sleeves.
Galley: On the closed-end fund side, we are focused on fixed-income closed-end funds, first and foremost. So finding opportunities where we believe there's a catalyst for that discount to narrow, because that is our excess return. So creating, number one, a diversified portfolio across a lot of fixed-income closed-end funds, and then generating excess return by trading the discounts predominantly.
As we said before, discounts are attractive today, so increased closed-end fund exposure as the discounts widen, and as discounts narrow or mean revert, take the chips off the table, go back to Jeffrey and his core fixed-income strategy and wait for opportunities again in the closed-end fund space. So, we're being reactive to volatility, which is actually good for us, so we're excited about the future. Interest-rate fear is actually a good thing for the strategy, but with it comes sometimes some more volatility.
Taggart: And how does Jeffrey go about selecting the securities, say, in his opportunistic sleeve?
Galley: In his opportunistic sleeve, Jeffrey has a risk-balanced approach between nonagency mortgage-backed securities and agency mortgage-backed securities. So he can tactically manage the duration, first and foremost, which a lot of investors are concerned with today. But having that barbell approach where nonagency mortgage-backed securities are predominately trading at a discount to their par value and agency mortgage-backed securities are trading at a premium, it gives you a nice balance between a risk-off and risk-on environment.
Taggart: This is a strategy that's about creating income for investors, but also, as you said, you're trying to look at risk-adjusted total return. So in your mind, ideally what type of investor should be interested in this fund?
Galley: First, probably an investor that understands closed-end funds and understands that they tend to be inefficient many times. So you can generate excess return by trading off of the discount, which is unique only to closed-end funds. I think that is a characteristic of our investors. Investors that tend to be contrarian, meaning that we tend to buy when everybody else is selling and sell when everybody else is buying, so an investor that can embrace that I think will appreciate the fund and the opportunistic nature that we take.
Taggart: This fund was launched at the very end of 2010, so in 2011 and 2012, the fund outperformed the Barclays Aggregate and the Morningstar Multisector Bond category average, but in  it's lagging both so far. What would you ascribe that to?
Galley: Number one, it's definitely the closed-end fund component [that] has lagged, obviously, because of closed-end funds are down in many cases 8% year to date. So if you were to compare the fund to the overall closed-end fund space, we've definitely outperformed ... We've lagged the Barclays Aggregate, I believe, by 20 basis points or so the last time I checked year to date, so not drastically. I would also say looking forward, we're really excited about the opportunity that we have in front of us. There [are] going to be periods of time of underperformance, but that underperformance usually sets us up for a pretty good opportunity. As I said before, we can increase the closed-end fund exposure in that environment and hopefully returns will come in the back end.
Taggart: Right, because part of being a contrarian investor is that you're catching a falling knife, eventually--you talk about mean reversion--the fund goes back up.
Galley: Exactly, and we don't necessarily feel like we're catching a falling knife, because the great thing about a closed-end fund is you know what it's worth, and so it's not like a stock, where it's only as good as your estimate of the intrinsic value. So because you know what it's worth and the discount is just widening out, it's more of just a sentiment play and betting against the irrationality of investors.
Taggart: Excellent. Well, thank you Patrick for walking us through this fund and best wishes for the future. Thanks for joining me today.
Galley: Thanks, Mike.
Taggart: For Morningstar, I'm Mike Taggart. Thanks for watching.