Mike Taggart: Hi. I am Mike Taggart, closed-end fund strategist with Morningstar. With me today is Patrick Galley. Patrick runs the RiverNorth Core Opportunity Fund. It's a 5-star Morningstar-rated fund, and it invests in closed-end funds and ETFs.
Patrick, thanks for joining me.
Patrick Galley: Thanks, Mike, for having me.
Taggart: Lots of times investors don't have a lot of experience with closed-end funds when they first come to closed-end funds. And so they bring with them the frameworks that they have built up over the years for bonds, for stocks, and for mutual funds, simply because they haven't created a closed-end fund paradigm through which to look at these things.
Because of this, there are all these rules of thumb that keep coming across my desk from people who invest in closed-end funds and from those that don't invest in, or even hate closed-end funds. These makeshift rules cover when to invest in closed-end funds, when not to, and what attributes you should look for.
And I thought that with you here today, we could kind of walk through maybe five of the most common ones that I hear and kind of get your take on them.
Galley: Sounds good.
Taggart: The first one is, never buy closed-end funds because they use leverage.
Galley: Well, lot of closed-end funds, almost all closed-end funds use leverage. Approximately 70% of closed-end funds use leverage in their capital structure. The purpose for using leverage first of all is to enhance the yield. I think leverage is very favorable in an environment like we are in today, with a very steep yield curve, when the funds can borrow on the cheap and invest in higher-yielding assets. That's very attractive and accretive to the fund's yield. So we think leverage is definitely favorable.
It is a double-edged sword though, as probably some of your readers are concerned about, obviously, as leverage increases the volatility of the fund. So I think for investors in closed-end funds especially that are using leverage, they need to look at it at the portfolio level, their portfolio level, and take that into consideration on how that volatility affects their overall portfolio. At RiverNorth we incorporate that leverage, that additional volatility into our portfolio analysis, and determine how much exposure we are really taking to various assets classes.
Taggart: Absolutely, and I think that's a smart way to look at it. So on the one hand you get the benefit of higher distribution rate on the other hand you do have that increased volatility. I'd also like to remind people that the amounts of leverage used within closed-end funds is highly regulated, and the average right now among leveraged funds is about 30% of their net assets. So we are not talking like crazy leverage that some of the investment banks got into, it's nothing on those levels.
Galley: That's right.
Taggart: Yes, the second rule of thumb is, never buy a closed-end fund because they trade at discounts and premiums and not at their net asset value.
Galley: That's why RiverNorth is in business. I mean, that's what we do. We take advantage of those discounts and premiums associated with closed-end funds. We think that variance of that discount and premium is the opportunity to generate additional return. If a fund is trading at a 10% discount and it narrows just to 8%, that's a 2% additional return above and beyond what the underlying assets did, even if they went up or down.
So, that's excess return; that's what we consider alpha. We love that as investors. We think that's a great risk-adjusted alpha versus having to take company-specific risk or sector risk, like a lot of stock managers or bond managers would have to do to generate a 2% additional return on a portfolio. And as you know, closed-end funds are fully diversified, and they publish their net asset value or their intrinsic value on a daily basis.
Taggart: Some of them don't.
Galley: Some of them don't. You are right. Correct.
Taggart: The other thing I always like to point out is that we invest in stocks. If an investor puts money in an individual stock, they don't know what the actual value is of that individual stock. And then these things trade at various price/earnings ratios, price/book values, it's a similar thing. Then when you aggregate that into a closed-end fund, that net asset value itself is based on the market values of the underlying things but not on their intrinsic values of the underlying portfolio.
Galley: That's right.
Taggart: The third rule of thumb, again related to discounts and premiums, is never buy a closed-end fund at a premium. What do you think about that?
Galley: Well, we look at discounts and premiums at a relative basis, so, it's not the absolute discount and it's not the absolute premium that we get concerned with or excited about. So, a lot of closed-end funds that trade at extreme discounts are trading at extreme discounts and probably will for the rest of their life potentially.
Taggart: When you say relative discount, can you explain what you mean, so our viewers will have a better understanding?
Galley: So, how we look at discounts and premiums, we look at them on a relative basis to how that current discount or premium is trading compared with its historical self, compared with its overall peer group, and then also the overall closed-end fund space. So, for example, if the whole closed-end fund space is widening out, yeah, you might want to be more cautious and be a little bit more patient investing in that closed-end fund, especially if its peer group is widening out, as well. So, for example, in 2008 when high-yield bonds were widening out drastically you wouldn't want to hold the line and say, this 20% discount is a fantastic opportunity when its peers are now trading at 35% discounts.
Taggart: Right, exactly. So, what you just said there kind of leads into the fourth rule of thumb: only buy a closed-end fund if its trading at a 15% or more discount to its net asset value.
Galley: Yes, and my previous example was an extreme environment, that's never occurred except in 2008, which was seven sigma event. So, 15% discounts are actually a pretty wide discount to come by, and like I said earlier, if you're waiting to buy something at a 15% discount, you might be stuck in that security for a very long time.
So, its great to own something for $0.85 on the dollar, but we would have to ask ourselves what's the catalyst for that discount to narrow. A lot of times, when you are looking at closed-end funds, for example, if a fund were trading at a 5% premium and now is at a 5% discount that potentially is a better opportunity than a fund that went from 10% discount to a 15% discount.
Taggart: Absolutely, you just mentioned it like you need to look at the relative discounts on premiums as well as the absolute discounts on premiums, but also ask yourself, what was the catalyst that got us down here? You could be catching a falling knife in the severe market downturn. Or what's the catalyst to get me back up to convergence with the net asset value? And obviously with discounts and premiums, you know the thing to keep in mind for everybody, is that they're based on the share price and the net asset value. That discount could narrow because the net asset value has fallen down to the share price.
Galley: That's right.
Taggart: And you are going to outperform the assets within that fund because your share price would be zero and that fund would have fallen.
Galley: It's still excess returns.
Taggart: Right. It's still excess returns, but like people say, you can't eat excess returns, right?
Taggart: And then the last one I have for you is never buy a closed-end fund that includes return of capital as a portion of its distribution?
Galley: Our take on that is, return on capital is definitely a positive, if the fund is trading at a discount. So, for example, if you have a fund trading at a 10% discount and it has a 10% return of capital, and that's it, you're getting 1% of your money back per year that's excess return. I mean that's 10% times 10% is 1%. So, you can't get that anywhere else other than the inefficiency of the closed-end fund structure.
Now, I think the story is a little different for funds that are trading at premiums. As you know, Mike, a lot of funds that are trading at huge premiums also have a lot of return of capital. It becomes a compounding effect on that premium. I just caution your readers to be more careful on funds trading at premium that have a large return of capital.
Taggart: Absolutely, and I would like to remind people that there are different types of return of capital, there is destructive return of capital, where people are just getting their money back. And there is constructive return of capital, where that's coming mostly from unrealized capital gains in the portfolios. And then there is a pass-through that the MLPs give. But I think that's good advice, to avoid funds trading at premiums when there is a large percentage of destructive return of capital present in the distribution.
Well, thanks for walking through there and helping our readers with their rules of thumb. They are hopefully starting to create a closed-end fund paradigm for themselves as opposed to their stock paradigms and their bond paradigms. Thanks.
Galley: Thanks, Mike.
Taggart: I am Mike Taggart. Thanks for watching.