Sunday, 25 September 2016
Last updated 1 day ago
Oct 7 2013 | 2:12pm ET
By Tony Cutinelli and Andres Lucas
Co-Managers, Global Partners Fund
Much has been made of the underperformance of hedge funds against major equity indices since 2008. Setting aside the selection bias and relative uselessness of hedge fund indices (vs. the top performers), the incessant drumbeat of negative headlines will rightly cause some to question whether the heydays of equity hedge fund strategies are over.
There is one sector of the equity markets, the Closed End Fund (CEF) market – a $274 billion subset of the broader market – that still holds opportunity for consistent repeatable alpha generation without fear of insider trading, excessive leverage or headline risk. It is the market structure of CEFs that provides consistent opportunities for a few knowledgeable managers to deploy limited capacity strategies and generate consistent outperformance.
Closed End Market Background
Closed End Funds are effectively listed mutual funds that trade at a discount, premium or equal to their net asset value of the underlying investments. Price to NAV ratios have ranged, historically on average, from 10% premiums to 35% discounts as a result of a number of factors including interest rates, market sentiment, dividend issuance and internal management quality. A fund affiliated with Bill Gross may trade at a premium…a lesser well-known manager may trade at a discount.
There are 600 listed Closed End Funds – 387 fixed income and 213 in equities. Within these asset classes, there are a wide range of strategies from covered call writing to high yield strategies.
While straightforward on the surface, understanding the drivers of NAV premiums and discounts is how managers generate their edge and investment return for clients. In addition, the market structure of the closed end fund space, specifically the seasonality of specific transaction behavior, can be anticipated and liquidity provided to the market to generate consistent outperformance.
The Seasonal Opportunity
Retail ownership of Closed End Funds is significant – on both an absolute basis and relative to the retail ownership of the overall equity market. While there may be similarities between the factors that institutions and retail take into account for buying a CEF – interest in a sector, NAV discounts, hot manager, retail selling behavior is vastly different from those of institutions and is well documented and repeatable. Chiefly, retail generally holds winners and sells losers at the end of the year to either create or avoid taxable events whereas institutions change portfolios based on investment strategy or asset inflows/outflows. These transactions – which occur across the board - cause price/NAV ratios to widen or narrow over the period creating opportunities for sophisticated, informed portfolio managers to anticipate and capture the alpha as the spreads revert to regular levels after the first of the year.
In addition to seasonal transactions, a select subset of Closed End Funds issue an additional dividend. The dividend issuance creates another short-term opportunity to trade a temporary movement of Price/NAV. However, not all dividends are issued equally and knowledge of the cash-flows and balance sheet is critical to determine the length of impact to price/NAV ratios.
While seemingly straightforward on the surface, there are a number of factors that make capitalizing on the CEF opportunity complicated. It is critical to know the fund leadership, rational behind the extra dividend and be on alert for targets of activists – who regularly monitor the CEF space. Profiting in this space is made more complicated by the capacity limits necessary to move nimbly to take advantage of the opportunities with the greatest risk adjusted return. The large funds are locked out of this market – creating fertile, consistent opportunities for niche specialists.
Tony Cutinelli and Andres Lucas co-manage Global Partners Fund, a Closed End Fund specialist. For further information on the CEF market please contact firstname.lastname@example.org