We have been investing in closed end funds for our clients for more than a decade. Over that time, we have developed an extensive knowledge of the unique nature of that market and the intricacies of how closed end funds operate for investors. Since March of 2009, we have applied this knowledge in managing the Essential Absolute Return strategy with excellent results until the last twelve months.
In the early days of this strategy, we invested primarily in corporate action situations that were low risk and which provided relatively steady and predictable returns. Many of those corporate actions were a direct fallout of the 2008 financial crisis. As the effects of that crisis faded, so did the number of opportunities of this type.
More recently, we have focused on convergence trading. We believe the closed end fund market is structurally inefficient which gives rise to temporary mis-pricing of assets, relative to their “normal” value. We try to buy mis-priced funds, and then wait for the pricing to return to average or normal levels. These types of opportunities tend to give rise to more volatile return streams (both positive and negative) and, because we never know when markets will return to normal pricing, the timing of such returns is uncertain. However, because of the leverage inherent in most fixed income-oriented closed end funds, our clients earn a high current income stream which serves to mitigate somewhat the risk of price declines.
Over the past twelve months, closed end fund discounts have widened to levels not seen since the financial crisis of 2008. Yet, there has been no crisis, no significant widening of spreads (except in a few emerging markets where we have limited exposure), and no dramatic changes in the levels of short or long term interest rates. There have, however, been periods of market uncertainty caused by concerns about the US Federal Reserve raising interest rates, a potential Greek default or exit from the Eurozone and China’s boom and bust A share market. These events had relatively little impact on our holdings’ underlying net asset values. Yet discounts continue to widen.
This time period has left us wondering if something has fundamentally changed in the closed end fund market. There have been a few developments: (1) the market for new closed end funds is quite muted and new funds that are being brought to market have more innovative structures designed to limit discounts; (2) the number of institutional investors has grown to the point where pure corporate action arbitrage opportunities are now rare; (3) fixed income exchange traded funds continue to gain popularity, potentially distracting investor interest away from closed end funds; and (4) investors have been hearing for years that the end of bond bull market is upon us and they need to prepare for rapidly rising rates.
The first two factors should actually bring more rational pricing to the closed end fund market, not less. The last two factors may actually be depressing the demand for closed end funds among retail investors, making a return to rational pricing more difficult. We believe the fourth factor — fear about the impact of rising rates — is likely the biggest contributor. For many reasons, we believe this fear is overblown.
Over the course of the past year, we have continued to selectively add to positions in closed end funds that meet our investment criteria, only to see discounts on these funds widen further. And we have allocated additional client (and personal) assets to this strategy, believing that the opportunities now present are extraordinary. We hear the same story from our fellow institutional investors in closed end funds. Here is a chart recently published by RiverNorth, a well-known manager in the closed end fund space.
Taxable Bond Funds: 30-day Moving Average Discount June.1997-June.2015
Source: Morningstar, Inc.
As you can see, discounts have only been at this level immediately prior to the last two recessions. In 2000, discounts quickly recovered, even before the recession fully kicked in. In 2008, the financial crisis wreaked temporary havoc with all financial assets before a strong recovery kicked in. We believe this time period is more likely to be like the early 2000s but there is of course no assurance that it will turn out that way.
We are exercising patience in waiting for prices to return to more normal levels with the comfort of knowing that we are able to buy the assets of closed end funds at 10-15% discounts off the prices available directly or through open end mutual funds or exchange traded funds.
July 30, 2015 Essential Investment Partners, LLC