Mike Taggart: Hi. I am Mike Taggart, Closed-End Fund Strategist at Morningstar. Today I'm here with Patrick Galley of RiverNorth Core Opportunity Fund.
Patrick, thanks for joining me today.
Patrick Galley: Thanks, Mike, for having me.
Taggart: One of the things that Patrick does at the Core Opportunity Fund is invests in closed-end funds. And so, I thought it would be interesting, Patrick, for you to share with our viewers what a professional money manager looks at when investing money in closed-end funds.
Galley: Thanks, Mike. Yeah, the three things we really look at as far as a catalyst for the discount to narrow in a closed-end fund, the first is doing a lot of statistical analysis on those discounts and looking at how they are currently trading relative to its peer group and relative to the overall closed-end fund space.
Taggart: Are you looking at the absolute discount or relative discount?
Galley: The absolute discount is important. We love buying a closed-end fund for $0.85 on the dollar when it's trading at a 15% discount. That's obviously a great thing. A lot of times the discounts trade at wide discounts for many reasons, and there's really not a catalyst for them to narrow. So, that brings us to the relative discount and we do look at them on a relative basis to their peer groups and then to the overall closed-end fund space. That's correct.
Taggart: Yeah. When you are looking at an average discount, do you use like a six-month or three-year or how does that work?
Galley: A lot of times it's relative to what's going on in the marketplace. There are different environments that we work through. If you look back to 2008, obviously, that's a very different environment than we are right now. So, currently, we're looking at really where closed-end fund is trading since year-to-date. So, really a six-month back look. But sometimes it could be as far as 12 months.
Taggart: Okay. And then – so you get a group of – narrow them down to the ones that are trading at sufficient discounts, and then what's the second step?
Galley: The second step is really – let me back up from there because I think there could be some clarification. One closed-end fund that usually trades at a 5% premium that today is trading at a 5% discount, in many cases, that's a better deal, even though it's not that wide of a discount being at 5%. It could be a better trading opportunity than looking at a closed-end fund that was at a 10% discount and now is trading at a 15% discount because that only widened out 5%. We might be looking out and giving a little bit more focus to the fund that went from 5% premium to a 5% discount.
Taggart: I absolutely agree with you on that. We call those – that's a way I urge investors who are looking at this for long-term capital gain to look in the relative discount and a Z statistic. So you are kind of getting the standard deviation in there as well.
Galley: That's right. And the other thing we look at quite a bit out is the discount volatility and the NAV volatility. So there is the market price volatility, which includes the discount volatility, and then there is also the NAV volatility. The NAV volatility is just looking at the pure asset class of loan and how that trades. A good example would be the bank loan asset class. The bank loan asset class, a lot of times on a NAV volatility standpoint, it's not very volatile. It's got about zero correlation to the S&P 500. When you look at the market price volatility compared to the S&P 500, you are talking about 0.5 to the S&P 500. So, a lot more volatility.
Taggart: And then, what's the next stage in trying to determine how – if the discount is going to narrow?
Galley: Other than statistical analysis, we also look at corporate actions as a great catalyst for discounts to narrow. Probably the best example of a corporate action would be a tender offer. A lot of funds do a tender offer for their shares back at net asset value where they might be buying 10, 20, 30% of their shares at net asset value. This is a great opportunity to generate additional returns over that benchmark by getting your shares tendered at NAV.
Taggart: Okay. Excellent. And what's the third?
Galley: The third would be shareholder activism where shareholder activists a lot of times accumulate a large position on the closed-end fund where they start to push the board of a closed-end fund to take action and try to narrow that discount, either forcing them to convert it to an open-end fund or worst-case scenario, from the fund's sponsor standpoint, to liquidate the closed-end fund at net asset value.
Taggart: It doesn't seem that it happens very often anymore. I mean, they are still out there; they are still trying to do it.
Galley: That's right. I mean that's really the threat. The reality is usually there's a compromise before you get to that point. And one of the outcomes a lot of times is a tender offer and what we just talked about.
Taggart: So, essentially, your approach is, you take a quantitative view to get you kind of narrowed down, and then a quantitative view as to looking at that narrower universe that you've had from the Z statistic or the volatility that you look at, and then try to figure out how exactly – what the catalysts are going to be to narrow that discount?
Galley: That's right. We take a quantitative view, we take a fundamental view, and that also brings us to – we've only talked about discounts thus far. We need to talk about what's in the underlying portfolio. Especially if you are just investing in a handful of closed-end funds, you're going to be accepting manager risks, you might be accepting sector risk if that manager is making some bets.
And then, the most important is the asset class risk that you are actually investing in. A lot of times closed-end funds are trading at very wide discounts because the asset class is completely out of favor. We tend to like that because it's a contrarian view. It means the asset class is out of favor, we might be able to get a double discount, meaning a discount on the asset class plus a discount on the closed-end fund. But then other times the asset class is out of favor for very good reasons as well.
Taggart: Right. I mean it's – closed-end funds, I think, are definitely a playground for contrarian investors, but you need to still be wary of value traps. And it seems in closed-end funds the value traps aren't just the funds – a particular fund, it can be a whole sector of the closed-end funds depending on the asset class.
Galley: That's right. Real estate was a great example of that in 2008 where the asset class got decimated. Closed-end fund discounts were trading at 25, 30% discounts, but people just still didn't want to put money back to work in that asset class. If you were a contrarian, though, 2009 would have been a great year to be able to put some money back to work in that asset class.
Taggart: Right, because that was the year – but it's always tough to be the first one back in the water for sure.
Galley: That's right.
Taggart: So, any further advice for individual investors who might just be interested in not buying a fund of closed-end fund such as yours, but individual closed-end fund?
Galley: Yes. Probably my biggest word of advice is how do you trade a closed-end fund. Closed-end funds are typically are thinly traded. So by just placing a market order, you're going to get hurt. So you really want to watch what's going on with the intraday discount, finding an entry point where you say, I want to put some capital to work, I want exposure to that asset class and this is an attractive discount to jump in.
Taggart: Well, Patrick, thank you very much for joining me today. Appreciate it.
Galley: Thanks, Mike.
Taggart: I am Mike Taggart. Thanks for watching.