Mike Taggart: The allure of investing in closed-end funds. I am Mike Taggart, closed-end fund strategist at Morningstar. With me today is Maury Fertig of Relative Value Partners.
Maury, thanks for talking to me.
Maury Fertig: Thanks for having me.
Taggart: So, Maury, your firm invests over half a billion dollars in closed-end funds and ETFs. It's been in existence since 2004, but you've invested in closed-end funds going back to the '80s. What's the appeal of investing in closed-end funds?
Fertig: Well, I always found this a fascinating part of the market because of the ability for an asset to trade at a substantial discount with net asset value and sort of, what are the factors that affect that. We felt like this was one of the few areas that provided an asymmetric return profile, if you know what you're doing, pay attention and are diligent about your investment process. The reason for that is you really have an asset that's exclusively sold to retail investors in the IPO during the IPO process.
Taggart: So when it comes out, first, it's sold through the advisors to the retail investor?
Fertig: Primarily to a broker, the brokerage firms, yes.
Taggart: So the retail investors are on the bad side of that information arbitrage?
Fertig: Exactly. They are buying the funds, and they are generally buying a sector that's hot. They're buying a yield story, and they don't necessarily know what exactly they are buying. But they know they are buying a fund that pays a certain yield, and they're very happy with that. They don't really care about the discount or premium because they just care about the yield.
Then you get an environment – any negative environment in the market where the investor says, I've had this fund for a while, I want to sell it. Particularly if the price starts to go down, they are more inclined to want to sell it. And there is no natural buyer because there is nobody that has a vested interest in placing this fund.Read Full Transcript
Taggart: It's not in an IPO anymore.
Fertig: There's no money to make.
Fertig: There's no money to make. Sometimes, in extreme examples, the funds can go into a freefall because it sort of feeds on itself. So you get a fund that comes at $15, then somebody decides to sell it at $14, and then they seek a lower, and more sellers come out because they are scared it's going to keep go lower.
Taggart: Right. So, just kind of snowballs into these discounts – kind of the disconnect away from the NAV.
Fertig: Yes, exactly, and usually you need some type of market event to cause this to happen. Some of those could be the failure initially back in '07 of the Bear Stearns hedge funds caused the markets to get in an uproar. You generally need some type of spike involved, some fear in the marketplace that really brings the retail investor out to want to liquidate their holdings.
Taggart: So this year, some of the things we have seen are reductions of distribution rates, sell-side analysts' downgrades of funds, and people want to sell these things. So then is this where your firm just jumps in, knows what they – you've done the research, take advantage of the opportunities?
Fertig: Yes. That's where the opportunities come about. Let's take a month like April when everything is great and people are putting money into funds and discounts are tightening, that's not a very interesting investment environment to put money in. But when you have these events, when you have a downgrade because there's concern about a dividend cut or if there is a dividend cut, there tends to be a very large surge in volume, and you can get some very attractive opportunities present themselves. And they may only exist for a day or two or three, but if you are on top of it and you know the funds to begin with, you're in a position to take advantage of it.
Taggart: So it's a closed-end fund, so it is a fund. So you're getting diversification, a diversified portfolio. You're getting professional management of the fund. It sounds like the unique aspect of closed-end funds that your firm focuses on are the discounts. But some people like the fact that closed-end funds can use leverage. How do you look at leverage at your firm?
Fertig: Well, leverage is a two-edged sword very much. On the one hand, a lot of these funds have very low cost permanent capital structures in terms of locking in their borrowings. So that's a very powerful thing, particularly in something like municipals where you can't really get that on your own. On the other hand, you have to be very comfortable with the asset class and very comfortable with the fact that with leverage comes increased volatility and increased potential returns, but also downside.
We really experienced the worst of that in '08 when several funds had to de-lever at the worst of times. We'll have a certain percentage of our portfolio in levered funds at a given point in time and we'll be mindful of how much leverage and what the impact is on the total duration of a client's portfolio, what the overall interest rate risk is, and it definitely is a factor that somebody has to consider when looking at the overall risk of their assets.
Taggart: Because you don't want to be in ... in the fall of '08, some of these funds were forced to liquidate some of their holdings at the bottom of the market in order to meet regulatory requirements, thresholds for leverage.
Another aspect of closed-end funds, a lot of people like, especially now, are the higher distribution rates, the "higher yields" that you can get. I mean, do you take that into consideration at all or is it more like, well, our primary thing is the discount and then secondary is the distribution rate?
Fertig: Sure. We're going to look at all the aspects that will either potentially compress the discount over time, because if we can buy a fund simply at 15% and it goes to 5% discount, we make the market plus the 10%. So, that's clearly one of the factors. But high distribution or managed distribution can be an important part of the overall return, particularly if you buy the fund at a discount. Even if the discount stays – you buy a fund at 15% discount, the discount stays in place over time, but if you have a high distribution rate, you're actually getting back some of your net asset value at par – at full value – at a hundred cents on the dollar.
So we think that can be powerful. And that's also – not only is an element for us to look at, but we know the other investors will gravitate more towards the yield fund. So it definitely is a positive in terms of how the market looks at the fund and how the discounts will behave over time.
Taggart: Okay, Maury. Well, thank you very much for joining us today. Putting you on the right side of the information arbitrage equation, I am Mike Taggart from Morningstar.