Q&A: Closing In On Closed-End Funds

May 31 2011 | 12:40pm ET

Tony Cutinelli and Andres Lucas have managed annualized returns in excess of 10% since 2002 focusing on closed-end funds. The co-founders of Chicago-based CLC Management, Cutinelli and Lucas' long/short equity strategy focuses on funds trading at historical high or low variations from their net asset values. FINalternatives' Senior Reporter Mary Campbell spoke to Cutinelli about his Global Partners fund and the closed-end fund universe.

Tell us about CLC Management and the Global Partners and Global Partners Offshore funds.

Cutinelli: We run two funds pari passu; between the two there is a total of $38 million. The sole focus of the funds is U.S.-based closed-end funds. The strategy began in October of 2002; we’ve produced an annualized rate of return since then of 10.4%, net of all fees. The fund is based in Chicago, although my partner Andres works out of New York.

What opportunities do closed-end funds present as an investment?

Cutinelli: Closed-end funds trade as equities on either the New York, AMEX or NASDAQ stock exchanges, just like any other stock. The difference between them and mutual funds is that they trade on the stock exchange and there’s a set number of shares, thus the closed-end terminology. In general, 75% of the space is some form of fixed-income portfolio. The other 25% is usually focused on some sector or index of the general market. In the past few years, we’ve seen really specific ones that might just focus on MLPs, there are ones that focus on utilities, REITS, and they get as general as the S&P 500, or large-cap—just about any sector you can come up with, there’s probably a closed-end fund covering that and the fixed-income world.

What we’re trying to take advantage of is, unlike a mutual fund, where you can redeem your shares at the end of the day at the NAV, the price of the equity is traded so it moves independent of the NAV. So, based on market perception, management fees and sector, you can get volatile moves in the price versus the NAV. In the whole universe right now, we see funds trading at a 50% premium to their NAV and a few funds trading at 30% to 35% discounts and pretty much everywhere in between. We analyze the historic discounts and premiums that the individual issues trade at—that being said, if a fund historically trades at a 10% discount, it may always trade at a 10% discount. Unless you identify a catalyst where it’s going to shrink, it’s not of any interest. What we’d be interested in is once it moves to the outer edge of its historical range meaning, if something trades at an average of 5% discount we want to see two standard deviations away from that, so we’d want to see it trading at a 12% to 14% discount. That becomes of interest to us because we think if we can pick it up at that price, all things considered, at some point it should move toward that historical average of a 5% discount.

In a 2004 interview, you said your fund had few peers. Is that still the case?

Cutinelli: There are a few more funds that do what we do, that have been launched in the past few years. There’s definitely competition out there, but we still consistently see the volatility between those discounts and premiums that we can exploit and take advantage of, so there’s still a lot to do in the space. The biggest influence in the space, considering that 75% of the space is some type of fixed-income product, is interest rates. In this current interest rate environment, we see quite a bit to do, but if the Fed ever decides to raise interest rates it would most likely increase greatly the opportunity set because that causes us to adjust our historical pricing and we would see a lot more price movement.

Has your method of managing risk in the funds changed since 2008?

Cutinelli: Yes, it has: We’ve definitely added some steps since 2008 to manage our risk more. One of the more difficult things about the closed-end space is finding short stock . In 2008, unfortunately, we only had one broker relationship; it really limited our ability to locate short stock. Since 2008, we’ve added five additional relationships, we have six total now, so that increases our universe where we can borrow stocks.

The second is with the advent of VIX ETNs and VIX options we found when the discounts in our space just fell off the edge of the table and careened down to 40% and 50% discounts, the best hedge for the long side would have been long VIX, obviously that panic indicator spiked, so we’ve implemented a trading methodology where, based on the amount of net long we are, we always maintain a net long position in the VIX to help reduce the downside exposure. Those are the two big implementations we’ve taken to help prevent 2008 from happening again.

Has the closed-end fund universe grown since you started out and is there any particular area of interest to you now?

Cutinelli: It definitely has grown in the past few years. What we tend to see, in our research, is that 70% to 80% of the holders of closed-end funds are still retail investors. Of course, the big brokerage houses realize this, so when a certain sector gets hot, you will see an onslaught of offerings in that sector. I can remember three or four years ago, we saw quite a few covered call funds come out. Then, in the last two or three years, we saw quite a few funds focused on MLPs and recently, we’re seeing quite a few new offerings based on gold and silver is one area, and the other is floating rate senior bank loan funds. There’s been, I think, three or four already this year. So, the space is expanding, but it generally tends to expand into areas where the brokerage houses see retail investor demand.

What criteria do you use when choosing a closed-end fund to invest in?

Cutinelli: The first step is a basic screening process—we buy research from a few different data centers—and that screens for funds trading two deviations off the normal average. Once that gives us a list of possible investments, we then go deep into those individual funds. If it’s, let’s say, a bank loan fund, we’d want to look at the management—there are management teams in the space that are more respected than others—we want to look at the fees, we want to look at the duration, the credit quality, basically anything you’d analyze in a bond, we’re considering.

If it passes through all the screens and research that we do, and we’d consider a long-side trade, if it’s trading at a historically low discount and we’re positive on the space, we may just put that on as a long-side trade. If we don’t see it as something of extreme value, what we’ll then do is, within the same space, we’ll try and do the review process in reverse, meaning we’ll try to find a similar fund in that sector trading at the high end of its valuation as the short side to that trade.

Generally speaking, what is the weighting between long and short in your portfolio?

Cutinelli: Again, it’s going to be mostly based on the environment and interest rates. There’re basically three different scenarios we consider: We’re either in a rising rate environment, a declining rate environment or a steady rate environment. And right now, it’s pretty hard for us to go lower, but we consider it a kind of level interest rate environment. With interest rates this low, we still have a long-side bias to the fund, collecting some pretty good dividends, and still seeing some price appreciation. When we see the Fed change course, we will see a dramatic shifting in the weighting of the portfolio more towards the short side. I should say that, in bond funds, we’d definitely increase the weighting on the short side, but we’d probably increase our weighting in the floating rate funds because the key metric of a floating rate fund is that their interest rates that they’re charging on those loans float, so if the Fed starts to raise rates, they get to start raising the rates that they charge on those loans, thus it’s the one fixed-income product whose interest rate rises with the Fed’s, so it’s a good place to be in a rising rate environment.

Who is your target investor and what is your minimum investment?

Cutinelli: Minimum investment is $100,000. Our target investor right now is high-net worth investors and family offices.

If I’m, say, a family office, where does your fund belong in my portfolio and why should I be looking at you?

In general, the two main things that we like to point out to people are, we did have a rough 2008, but we’ve been in the business for well over nine years and the annualized return, net of fees, is 10.5%. That return is not correlated to the S&P 500 very much so, it’s kind of an uncorrelated investment. And the other thing is, in this current environment, where there’s the potential for higher rates, we would be a good alternative to your high-yielding junk bond allocation.


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