Profit on 'Gaps' in Closed-End Funds

01/03/2012 7:00 am EST

Focus: FUNDS

One way to enhance returns is by exploiting narrowing discounts in closed-end funds, which is Patrick Galley's strategy. He explains to how it works, and talks about his partnership with Jeffrey Gundlach of DoubleLine.

Kate Stalter: My guest today is Patrick Galley, Chief Investment Officer and Portfolio Manager at RiverNorth.

Patrick, you run closed-end funds, and I’ve also read some of your columns on the AdvisorOne Web site. So tell us a little bit about your strategies for capitalizing on market inefficiencies.

Patrick Galley: So what RiverNorth focuses on, we invest in closed-end funds, and we think they’re an inefficient investment vehicle, because they’re predominantly owned by retail investors. And the market price of a closed-end fund often deviates from the net asset value, so we’re able to make an enhanced return from the discounts associated with closed-end funds.

Given that retail investors are often buying and selling for irrational reasons, we’re typically on the other side of that, and when the discount narrows, it’s an additional return for our investors.

Kate Stalter: One of the things you’ve done is to partner with Jeffrey Gundlach of DoubleLine. Tell us about that partnership.

Patrick Galley: Sure. What RiverNorth’s philosophy is, from a standpoint of investing in closed-end funds, is you have to be opportunistic, and so you don’t want to have a portfolio that’s consisting 100% of closed-end funds. We want to have what we refer to as dry powder, and by partnering up with DoubleLine, DoubleLine manages a fixed income portfolio, which serves as our dry powder.

So when discounts are stagnant or there’s not much opportunity, DoubleLine is managing a core fixed-income portfolio, in addition to the hedge-fund strategy. We’re really getting paid to wait for opportunities in the closed-end fund space. So when investors get concerned, then discounts typically widen out.

We’re increasing our closed-end fund exposure, and we’re taking from the core fixed-income portfolio that DoubleLine is managing, and then when those discounts contract, that’s the excess return that we’re going after. We sell closed-end funds and replenish the core fixed-income portfolio at that time, and hopefully we can do it all over again.

Kate Stalter: So this is a pretty interesting distinction that you’re pointing out, in that your funds consist of other funds. Can you tell me a little something about some of the specific holdings?

Patrick Galley: For the DoubleLine fund, we’re focused predominantly on closed-end funds that are income producing closed-end funds, really ranging on the risk spectrum from convertible bonds to treasury bonds. But the great thing about closed-end funds is you literally can get exposure to any asset class possible, so investors that want equity exposure, they can get exposure to equities.

But for the DoubleLine fund, its objective is income and total return. So from that standpoint, we’re focused predominantly on income-producing closed-end funds. It’s a way for us to beat a benchmark simply by investing in closed-end funds that we think the discount can narrow.

Kate Stalter: Talk a little bit about seeking alpha. I understand that that’s something else you are known for.

Patrick Galley: Yeah, the alpha is really—I think a lot of people use that term loosely, and all alpha really means to us is beating a benchmark. A lot of stock pickers or bond managers, they make concentrated bets on certain securities or certain sectors in order to generate their alpha to beat their benchmark.

The unique thing that closed-end funds have to offer is that they are inefficient investment vehicles that you can buy a diversified portfolio of assets through one simple trade. If that discount narrows, that is an excess return above and beyond what the underlying assets even performed in that fund.

So we really don’t view our investment style as a fund of funds. We view it as more of a bottom-up selection in picking investment vehicles that have inefficiencies where we think the discounts can narrow to beat a benchmark. We don’t have to make huge tactical bets on certain names and sectors in order to beat a benchmark, but rather exploiting the inefficient vehicle.

Kate Stalter: Now another thing, Patrick, I wanted to ask you about today is yield. You had mentioned the idea of total return a moment ago, and obviously in these volatile market conditions we’ve had lately, a lot of investors have been favoring yield. Tell me how you go about that.

Patrick Galley: Closed-end funds are a unique investment vehicle because most of them have yield associated with them. Also, a lot of them implement leverage in their capital structure, so they borrow capital in order to make additional investments and get a higher yield, and I think that’s probably a misconception with closed-end funds in that they’re yield vehicles.

With that comes even more inefficiencies, and because a lot of closed-end funds have higher yields, and given the low yielding environment that we’re in, a lot of investors are clamoring for that yield. This pushes discounts narrow on those higher yielding assets. To that extent, high-yield closed-end funds today are trading at a premium.

So from RiverNorth’s standpoint, we do look at the investment outlook for closed-end funds from a total return perspective versus just yield. But I think you also have to take into consideration that retail investors will push closed-end fund discounts and premiums to irrational levels. So that’s why you have some premium funds trading at 50% or 60% premiums to their net asset value today, purely based off of investors going and reaching for their yield.

Kate Stalter: You’ve commented a few times today on how the closed-end funds do tend to be inefficient instruments. We started out by saying there might be some misunderstanding of what they are. What’s the best way that you would suggest for individuals who are listening to this today to properly get exposure to the closed-end universe?

Patrick Galley: I think the first step in investing in closed-end funds, because you can get access to virtually any asset class, you have to ask yourself, “How do I want my portfolio allocated amongst all the asset classes out there?” So don’t even think about closed-end funds.

Once you have your asset allocation for your risk appetite, then you can look at the closed-end funds and say, “OK, are there closed-end funds that are trading at substantial discounts to their net asset value, where I’m getting a margin of safety and the ability to generate even an additional return, because those discounts might narrow in the future?” I think that’s probably the best way to start constructing your portfolio when allocating the closed-end funds.

And then, as I mentioned before, we are high proponents of keeping dry powder on the sidelines, because discounts can widen out when fear increases in the marketplace. I think 2008 was a good example of that, where discounts got to very, very extreme levels. But it also was really an investment opportunity of a lifetime, where you could start buying closed-end funds at 25% discounts to their net asset value.

So having that dry powder is very key in constructing your portfolio to your risk tolerance, and not getting sucked up in just kind of day-to-day performance, but rather trying to hit those singles and doubles for your long-term performance focus.

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