Thursday, 23 March 2017
Last updated 15 min ago
Aug 29 2014 | 10:00am ET
When Maury Fertig and Bob Huffman, former Salomon Brothers coworkers, launched Relative Value Partners in 2004, the only people they knew with money were “other Wall Street people.” So they started managing money for money managers and today financial industry types still account for about half their clientele. RVP invests in closed-end funds, managing $950 million across a number of strategies, the oldest of which—their Balanced strategy—is up 7.33% on an annualized basis since inception in '04. Fertig spoke recently with FINalternatives' Mary Campbell about this niche market they've made their own for over a decade.
What is the investment opportunity represented by the closed-end fund market?
The real opportunity stems from the way they structure the distribution. It's a really horrific distribution model for the investors, but they buy billions of these things because brokers are really good salesmen: They still sell new funds at a 5% premium and make a nice commission...
Inevitably, you're talking about a fund that's distributed to all retail investors that generally aren't very sophisticated and that generally buy the assets at the wrong time—they'll buy the most bond funds when yields are the lowest and everybody's scrambling for yield and they'll sell when people want out, and unfortunately, they will get hammered because there won't be buyers at the prices that they paid.
For the patient investor that can play off of these sentiments, there is a tremendous opportunity when retail investors want to sell their closed-end funds. Wall Street has no interest in re-selling them, so it falls to investors that don't mind doing their homework and, understanding what they are buying, they can extract some tremendous values. You can build a portfolio at discounts of 10% or 15% to the net asset value of the bonds or stocks in the portfolio.
Can you give me an example of how this works?
DoubleLine Capital's Jeff Gundlach did a closed-end fund in April of 2013—almost the height of the mania of people looking for yield, yields were much lower than they are now—and he was raise $2.5 billion. Investors paid $25 and what they received was a fund with bonds in it worth $23.83. In May, Federal Reserve Chairman Ben Bernanke started talking about tapering and bond rates started to rise and investors started dumping their bond funds and—seven months after it came out—the fund went from trading at a 5% premium to its net asset value to trading at a 10% discount to its net asset value. In addition, because you had a rise in rates, the price dropped from $25 to around $20.
This created an opportunity for us: “I can buy Jeff Gundlach at 90 or 88 cents on the dollar and I can buy this portfolio of bonds and his expertise.” And then there's two things that happen: One is, you buy these assets at a discount and it's nice, because, it's not a theoretical valuation, they're valued daily and it's a real value. The only theoretical part is you may not be able to get the full value—it's not like you can buy it at a 10% discount and sell it the next day at full value.
But the other thing that's nice is, a fund like this paid 15 cents a month in dividends. The initial buyer got a 7.2% yield, so for the investor who came in at $20, their yield was 9%. There's a double whammy here in terms of benefit—not only do I get the assets at a discount, I have a greater yield because of the discount.
And then there's another incentive that the brokers have to sell once the fund's trading at a loss: It looks bad or reflects poorly on them so they tend to emphasize, “Take the tax loss and get out of this losing fund.”
How big is the closed-end fund universe?
In the U.S., it's approximately $250 billion. It's not insignificant but it's not massive.
What is your research process like?
The first issue is: What's the underlying asset? Is it a high-yield bond fund? Is it just a plain vanilla equity fund? We want to understand what the underlying asset is. And we look at things such as who the manager is, what their record is, what's the valuation, is it trading at a discount that's sufficiently attractive?
We establish that we want to own the assets, and then the question is, what was the catalyst that caused the discount and can we make excess return due to the market correcting itself or reversion to the mean or, also, some activist-type event?
What would an 'activist-type' event look like?
That's when there's a lot of institutional holders of a particular closed-end fund. Each of these funds has a board of directors that must be re-elected every year or two. The fund company that manages the money doesn't have a lifetime contract: It has to be voted on by the shareholders and the board of directors. The fund is sold to 100% retail investors but if it gets beaten up enough, it attracts institutional investors, such as us, and we can potentially effect change to induce management to remedy the discount. And that's another nice edge, because we're not taking extra market risk to get that return. But if we can buy something at a 10% discount and there's a tender or some type of event that gets us out with a 2% discount, that's a very nice excess return that we can capture.
How do you use exchange-traded funds in your strategy?
Our principal strategy is a 60/40 Balance—about half of our assets are invested that way. We're trying to beat the combination of the Standard & Poor’s 500 Index and the Barclay Aggregate Bond Index, and we've been able to do that over the decade that we've been managing the strategy. We'll move around the ratio of closed-end funds we have depending on the market conditions. So we're not forced to own closed-end funds, if we get to periods where they're not attractive—like the spring of 2013—we can own very few and we'll focus more on ETFs and, conversely, when the opportunity arises we can swap out and increase our closed-end fund ownership in the portfolio.
What are some of the funds you find attractive today?
One of our favorite funds is the BlackRock Credit Allocation Income Trust. BTZ is a multi-sector bond fund, which means it can invest in different asset classes in fixed-income, so it has a combination of mortgages, asset-backed and high-yield securities, and it's a $1.4 billion market cap. The factors we like about this fund are, first of all, it's trading at a discount of 13%, which is very steep. The fund also has some decent history; last year, which was the third-worst year for bonds since 1926, they managed to produce a positive return of 3.5% on net asset value, which we thought was phenomenal. They also increased their dividend last fall, and they're earning their dividend; at the market price right now, it yields 7.1%. It has an intermediate duration and some interest-rate risk, obviously, but not a lot compared to many other funds in the market.
This is a solid fund that is trading historically at a very depressed price and perhaps if 10-year rates stay in this 2.5-3% range for the time being, investors will start to flock to this fund and find it attractive.
Another fund we like is Eaton Vance Risk-Managed Diversified Fund. They use a variety of options strategies to provide lower volatility and produce a positive return. Last year, the underlying net asset value was up 16.5%. And what the investors get in return, they're not getting all the upside or downside of it, but it has a high distribution rate and pays a monthly dividend yielding 9.6%. Very attractive in this environment—it also trades at a discount of 8%.
Eaton Vance Management had to cut the dividend about four years ago, because it wasn't generating enough from the options and investors just dumped the fund in a pretty big way and it went from trading at a premium to trading at a discount. Eaton Vance has been very clear that they're going to attempt to keep the dividend unchanged and I think, over time, as that happens, more investors will come to this fund. And it's also trading cheaper than all the other Eaton Vance funds of a similar strategy—they have seven other covered-call funds that are trading at tighter discounts than this. So I think this is good for somebody who wants some equity exposure but they want lower volatility and are attracted to a fund with that level yield.