Finding Opportunities In The Closed-End Fund World

Closed-End Funds: A Somewhat Different Animal

The closed-end fund market is, by definition, somewhat of an inefficient market, compared to many other larger securities markets. Trading volumes tend to be smaller, there is less liquidity, and many investors tend to be the type that are more interested in long-term steady income rather than traders focused on shorter term, buying and selling with an emphasis on scoring capital gains, rather than generating steady cash flow.

The nature of the market, especially that it is “closed end” rather than “open-end” like traditional mutual funds, can be seen as both an advantage and a disadvantage, depending on one’s perspective.

In a typical open-end mutual fund, like the ones Vanguard, Fidelity, Schwab and other major firms sponsor and manage, investors initially buy their shares of the fund directly from the sponsor/manager. Later, when they want to sell it, the sponsor “redeems” it (i.e. buys it back) from them. In both cases – the initial purchase and the later redemption – the transaction takes place at the actual “net value” of a share of the fund (as measured on that particular sale day).

To take a simplified example, suppose a fund had total assets valued on a particular day at $1 million dollars, which means if all the assets in the fund (stocks, bonds, cash, etc.) were valued at market price on that particular day, it would add up to $1 million. Suppose also that the fund had issued a total of 10,000 shares. That means every share of the fund would be worth $1,000,000 divided by 10,000 shares, so each share would be worth $100. Another way to think of it is that if the fund were liquidated, and all of its assets sold at that day’s market price, each share would receive $100. That $100 per share is referred to as the Net Asset Value (or “NAV”) per share, and it changes every day to reflect the changes in the market prices of all the assets the fund holds.

Open-end mutual funds sell shares to new investors directly, issuing them at the current daily NAV of the fund. So everyone who buys shares of the fund on a particular day gets newly issued shares at the same daily NAV price. Meanwhile, any existing holders of the open-end fund who want to sell their shares and get their money back can approach the fund, which will “redeem” those shares from the investor, again at that day’s NAV price (the same price at which the fund is issuing new shares to that day’s new investors.)

Closed-end funds operate quite differently. A closed-end fund initially sells its shares through a public stock offering, just as a public company would. The money raised ($50 million, $100 million, whatever), minus the offering expenses, will be used to buy a portfolio of stocks, bonds or whatever asset classes the fund plans to invest in. On day one, the amount of money raised and the value of the assets purchased with the money raised, should be about the same. So to take the above example, if the public offering raised $1 million by selling 10,000 shares, and used it to buy $1 million of securities, then each share’s “basket of securities” (i.e. the pro rata portion owned by each of the 10,000 shares) would be worth 1,000,000 divided by 10,000, or $100 per share.

At least it would on day one. Every day, just like the open-end fund, the total value of the closed-end fund’s securities portfolio would go up or down, so the net asset value of each of the 10,000 shares might go up or down. However, unlike the open-end fund, with a closed-end fund there is no fund sponsor who is guaranteeing to buy back (“redeem”) your shares whenever you want at the current net asset value.

So if the stock market goes up and a fund’s total assets were now worth $1,100,000, with an open-end fund a shareholder could redeem their shares for 1,100,000 divided by 10,000 shares, or $110 per share.

But there is no such guarantee for the closed-end fund investor, who can only dispose of his/her shares by selling them in the stock market, like any other company’s shares. So the fact that the theoretical value (the NAV, or net asset value) may now be $110 per share, doesn’t mean the shares will actually sell for that in the marketplace. If the closed-end fund market were totally rational and efficient, then its shares would probably trade routinely for their actual NAVs. But for a host of reasons (expenses that are often higher than most open-end funds, less liquidity, more complex and less transparent asset classes, higher yields than typically available in other markets, etc.), closed-end funds trade at a range of prices, sometimes higher than the net asset value (which is called trading at a “premium”) and sometimes lower than the NAV (which is called trading at a “discount.”

Advantages of Closed-End Funds

Closed-end funds are not everyone’s cup of tea, but for certain types of investors and particular asset classes, they are very attractive.

Three major advantages closed-end funds have over open-end funds are:

• Closed-end funds can invest in more complex and illiquid asset classes that you probably wouldn’t want to invest in if your fund were “open end” and your investors could redeem their money on demand at a moment’s notice. That’s why closed-end funds are ideal for more complex and less liquid assets like senior corporate loans, high-yield bonds, collateralized loan obligation (“CLO”) debt and equity, master limited partnerships, private credit, venture capital and private equity type investments. If held in an open-end fund, assets like these would likely require major “haircuts” if they had to be sold in a hurry to satisfy fund investors’ redemption requests. But closed-end fund managers don’t have to worry about that, and can focus 100% of their energies on ensuring portfolio performance, credit quality, and other issues related to maintaining dependable cash flow
• Another advantage is related to that one. Open-end fund managers have to maintain a cash cushion (5%, 10%, or whatever, depending on their asset class, its liquidity, and their fund’s experience with shareholder turnover and redemption history) to cover daily redemptions, since they never know from day to day exactly how many fund holders will be demanding their money back, or what the daily inflow of new investors may be. Closed-end fund managers don’t have to worry about holding part of their portfolio in reserve, so they can invest it to the max and put all their capital to work. For asset classes like the ones we invest in – corporate loans, HY bonds, CLOs, etc. – that yield 10% and higher, not having to hold 10% or so in cash makes a big difference in total returns over the long term. (Even with a cash cushion, open-end funds can get into trouble and encounter “runs on the fund.” Here is an article about the Third Avenue Focused Credit fund, a “distressed debt” open-end fund that collapsed after a “run on the fund” back in 2015. It is a classic case of a fund that, had it been structured as a closed-end fund, would likely still be alive today.)
• The other big advantage is that careful investors, who time their purchases for when funds are selling at discounts to their net asset values, can buy assets for less than their underlying market value, thus ending up with $100 of assets that we’ve only paid $90 or $95, or sometimes even less for. This means we have more assets “working for us” than we had to pay for. If the underlying assets are yielding, say, 8%, but we only paid 90% for them, it means the yield to us, on the money we paid, is actually almost 9%. That means a lot over the long term, both because our money is compounding at a higher rate on the initial capital invested, and also because we have a lower risk profile on our 9% yield than we would have if we’d had to buy assets that really paid 9% on their face value, rather than 8%.

So Much for the Theory

That’s the “theory,” and anyone who wants an even deeper dive into the advantages of closed-end funds might want to read “The Alchemy of Closed-End Funds.”

But any market with all the idiosyncrasies of closed-end funds is sure to attract other sharp players besides all of us retail types, and closed-end funds definitely have. In particular, there are a number of “activist” firms that focus on finding funds that they believe are under-performing, which they generally define as selling at large discounts for extended periods of time. The activists, of whom the major ones are SABA and Bulldog, will buy up a large minority position in the fund and then try to pressure fund management to do things that will increase the fund’s value, either for the entire shareholder base, or sometimes more selectively just for the activist fund and other investors that have “piggybacked” onto its strategy.

Often the activists will try to get the fund to do a “tender” offer, where it offers to buy in a number of its own shares from existing shareholders, at a price that is above market price but below the fund’s net asset value. Doing that puts money in the pockets of the shareholders who choose to participate in the tender offer, since they get to sell their shares (some of them at least) at a higher price than they are “worth” in the market. Tender offers are always set at a lower percentage than 100% of the fund’s shares, so the active and alert shareholders who take advantage of them tend to make money on the deal at the expense of the more passive and less alert shareholders who ignore it and fail to participate. (Missing out on what is a “zero-sum game” where the non-participants lose. More info here.)

Invest with the Big Kids

Here are a few current examples where astute investors may find an opportunity to hop on the bandwagon with activist investors. One has gotten a fair bit of attention, while the others very little that I’ve seen.

• The first is SABA’s aggressive attack on a number of BlackRock closed-end funds, accusing them of ignoring the good governance practices that BlackRock insists other corporate managers follow. Whether or not SABA is right, BlackRock has taken them seriously and has also taken steps that retail investors like us can take advantage of regardless of which of the two ends up winning. Two of the funds that SABA has targeted are BlackRock ESG Capital Allocation Term Trust (ECAT) and BlackRock Capital Allocation Term Trust (BCAT). ECAT has only been around for about 2+ years, so there isn’t much of a track record, but it did achieve a total return of just under 30% over the past year, which isn’t too shabby, to say the least. But it sold at a discount of about 20% a few months back, which it closed to 10% a few weeks ago and currently sits at a 5% discount. As a result of SABA’s pressure (they own a reported 30% of it, $507 million worth), ECAT doubled its distribution to a yield of currently 20%. With a 20% yield and still sporting a 5% discount, it seems to me the opportunity in ECAT is likely not over. By the way, another big institutional closed-end fund player, RiverNorth, owns about $75 million of ECAT’s shares.
• Similarly with BCAT, which has a story somewhat like ECAT’s. A discount close to 20% a while ago, now compressed down to a discount of just under 5%, and a 26% total return over the past year. BlackRock more than doubled BCAT’s distribution a week ago, so its current yield is 20%. SABA is reported to own about 15%, or $276 million worth, and RiverNorth about $112 million.
• With newly raised distributions and so much institutional and activist interest, I don’t think the ECAT and BCAT story is over. Getting less attention so far are two other situations.
• abrdn Life Sciences (HQL) is paying a big dividend yield (14%, raised about 50% since January) as well as selling at a large 13% discount. SABA and a number of institutional buyers have taken sizable positions, so there should be some additional pressure on the fund to bring that discount down. SABA owns almost 10%, which represents about a $35 million investment. By comparison, HQL is only a fraction of the size of ECAT or BCAT.
• Gabelli Dividend & Income Trust (GDV) sports a price discount of 16%, along with a solid longer-term record, which was sure to attract interest among activists and the institutional investors who piggyback along with them. SABA owns about $50 million of GDV, which is not a large percentage, but with a discount of 16% I would not be surprised to see continuing and growing interest from SABA and others.

Closed-end funds are an acquired taste for many investors. But for those willing to take the plunge and learn about the finer points and idiosyncrasies, it can be worth the effort. It is important to remember, since this seems to confuse many readers who comment on articles about specific closed-end funds, that closed-end funds are NOT an asset class. They are merely a vehicle for holding an entire range of asset classes. You can find closed-end funds with all sorts of different characteristics, which reflect whether the particular fund focuses on stocks, investment grade bonds, high-yield bonds, corporate loans, REITs, MLPs, utilities, infrastructure, emerging market, taxables vs. munis; as well as how aggressive or conservative it may be, whether it’s leveraged or not, etc. You can’t generalize about “all CEFs” any more than you can about “all mutual funds,” or “all ETFs, or “all stocks.”