Corporate actions in the closed-end fund market are heating up. To understand why this happening and why it is accretive to investors, let's quickly discuss the life cycle of a closed-end fund.
Historically the best time to invest in closed-end funds is during their Midlife and Late Life periods for three reasons:
1. Investor sentiment is low causing wide discounts
2. Shareholder activism and corporate actions are high
3. If reached, the death stage of the fund instantly eliminates a fund's discount, benefiting investors
We are seeing significant mid and late life cycle activity. Since January of 2016, many fund families have announced share repurchase programs. As outlined in their year-end letters, fund management teams did this not only to energize their fund’s discount, but also because the management team admittedly couldn’t find a better investment than their own fund at an extreme discount. These repurchase programs are accretive in nature for current shareholders.
In the last three months we’ve also seen heightened activity in closed-end fund managed distribution policies. A managed distribution policy increases investors’ cash flow and is a direct transfer of wealth from the manger to the shareholders. Fund managers adopt these policies when they fear that activist investors will step in and liquidate the fund via proxy vote. We find that funds with managed distribution policies provide us opportunities to collect higher yields and provide us exposure to funds that are targets of fund activism. On April 1st, Zweig Advisors announced a 67% increase in their dividend distribution rate for their two funds, ZF and ZTR. Two business days later they announced tender programs for both funds. The initial offer was to purchase 15% of investor’s shares at a -2% discount to the fund’s NAV. At the time of the offer, the discounts of the Zweig funds were right around -11%. This non-conditional offer will commence on or before April 29th.
This increased corporate action environment creates ideal conditions for a specific closed-end fund run by none other than the pioneer of closed-end fund activism, Phillip Goldstein. Goldstein’s Special Opportunities Fund (SPE) uses 50% of its assets to invest in and then pressure closed-end funds to complete an accretive corporate action. The other 50% of his fund is invested in common stocks with very specific situations where pending corporate actions are expected to unlock dormant value. True to his own demands for the closed-end funds he’s invested in to address their discounts, Goldstein implemented and recently increased a share repurchase program for his own fund, which currently trades around a -13% discount.
We are excited about and greatly welcome the increased level of corporate actions. Not only do corporate actions narrow discounts, but the volatility of discounts becomes more predictable and the liquidity of funds increases. We also believe that corporate actions tend to create a snowball effect – funds engaging in corporate actions put pressure on other funds to act as well.
Corporate action activity and improving investor sentiment are supporting our optimistic outlook for closed-end funds and we have numerous avenues to provide you access to these opportunities, including through an Individual Retirement Account (IRA). Let us know if you'd like to learn more.
Since our last letter, the average discount of closed-end funds seems to have stabilized around 10%. The rally we had in October briefly pulled discounts up, but overall sentiment hasn't yet strengthened to a point where investors will jump back into closed-end funds and narrow discounts. Even so, as we go into the end of the year we see many opportunities in the closed-end fund market – some fundamental seasonalities, others specific to the current state of US markets.
Historically speaking, the next several months have been our best performing months, mostly due to the seasonality. Closed-end funds are required to distribute most of their realized gains and investment income by year-end. By analyzing corporate filings throughout the year we are able to identify closed-end funds slated to pay significant year-end distributions. Another year-end seasonality of closed-end funds is tax loss selling. Harvesting losses by year-end can help investors minimize tax consequences. The tug-of-war between wanting income and avoiding taxes causes significant discount volatility, creating opportunities for astute investors.
We believe the old saying “sell the rumor and buy the news” applies directly to current state of the US markets. Since August, the market has been selling (priced in) the rumor that the Federal Reserve will soon end its seven year stranglehold on interest rates. The investor sentiment associated with this selloff put downward pressure on discounts this year. However, we believe that the reason behind a zero rate liftoff will be the news that investors have been waiting to buy – a hike in interest rates is the Fed's way of saying that the US economy is finally healthy enough to remove their 2008 emergency Zero Interest Rate Policy, which should boost overall investor sentiment. This same sentiment that pushed discounts lower will also elevate discounts to more normalized levels.
How do closed-end funds perform in a rising rate environment? Starting in June of 2004 rates moved from 1% to about 5.25% two years later. Examining the same 500 closed-end fund universe we used in our last newsletter, we studied the performance and discount behavior of our closed-end fund universe vs. the S&P 500 over this two year period. What we found was that the average discount of our subject universe narrowed slightly from 6% to 4.35%, causing our universe of closed-end funds to outperform the S&P 500 by 6%. However, since the current day average discount of closed-end funds is around 10%, we also wanted to observe how a group of closed-end funds with discounts more representative of present levels performed over the same time period. To do this we only included funds that were trading at a 10% or greater discount into our universe. The results were even better. The average discount of this universe narrowed from 13% to 8.20% over the same two year period, which contributed to a 21% outperformance against the S&P 500. This suggests that deeply discounted funds offer greater risk/return profile in the face of rising interest rates when compared to the entire closed-end fund universe.
The intersection of improving investor sentiment, year-end closed-end fund nuances, and historically wide discounts are presenting a timely investment opportunity. One thing is for sure, the year-end nuances will be over by the start of the new year.
Closed-end fund discounts are extremely wide – have you heard this from us yet? Rather than just re-emphasizing the current state of CEF discounts, we wanted to share with you our research regarding the returns of CEFs 12 months after reaching extremely wide discounts.
China’s “Black Monday” sent markets reeling across the globe and accelerated selling pressure on major US indicies, only to be followed by two days of sharp volatility in US markets. This price action has been a headwind to our strategy, edging CEF discounts to wider levels since our last communication. So with the entire CEF universe averaging an almost 10% discount, where do CEFs go from here?
Studying 500 currently traded CEFs, which represent 92% of the CEF universe, we tracked both the average discount and rolling 12-month returns of the CEF universe going back nearly 25 years. What we found was that in prior instances when the CEF universe traded at more than a 9% discount, closed-end funds returned an average of 22%+ over the next 12 months. By comparison, the 12-month total return of the S&P 500 for those same time periods averaged only 0.28%.
The last time in recent history that CEFs broke below a 10% average discount occurred when Lehman Brothers filed for bankruptcy in September of 2008. In the 12 months following the collapse of Lehman Brothers our KGR Series I (Global Equity) returned 25.58% and our KGR Series II (Emerging Markets) returned 106.94%. By comparison, the S&P500 lost -6.92% over the same time period.
Although past performance is no guarantee of future returns, history suggests that investing in highly discounted CEFs has been an intelligent move.
As always, please feel free to reach out with any questions.
Most investors don't buy closed-end funds, rather, they are sold closed-end funds. So in times of market stress, closed-end funds are first up on the chopping block, simply because investors are unfamiliar with them. Consequently, closed-end fund price-to-NAV discounts widen out when the word “crisis” is posted in news headlines.
In May of 2010 the Prime Minister of Greece sealed a three-year EU/IMF bailout deal. The package amounted to €110 billion and kicked off a series of opportunities for KGR Series II to extract alpha from the market. As you can see in the chart below, closed-end funds experienced an amplified sell-off on several Eurozone headlines, followed by a compression of price-to-NAV discounts.
Since the initial bailout of Greece in 2010, KGR Series II has outperformed its benchmark, iShares Emerging Markets Index Fund (NYSE: EEM), by 65%+.
Recent Greek financial crisis headlines are causing the discounts of closed-end funds to widen to historic levels. As discounts continue to widen, not only from Eurozone headlines, but also from talks of U.S interest rake hikes and from Asian market volatility, investors have the opportunity to buy these funds and their underlying assets at rarely seen discounts.
Statistically speaking, 36% of the closed-end fund universe is trading at a price-to-NAV discount that is two standard deviations below their previous one year average discount. This suggests that 200+ closed-end funds are trading in a range that is only expected to occur less than 2.3% of the time.
Contact us for more information on the current opportunities our Series of Funds are taking advantage of.
In a letter to his shareholders in 2008, Warren Buffett summed up the philosophy of King Muir’s investment strategy saying, “Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” In this month’s letter we would like to illustrate a few ways that we evaluate our favorite marked down merchandise, Closed-End Funds.
Liberty All-Star Equity Fund (NYSE: USA) is a Large Cap Core Equity fund and is a top three holding in KGR Series I, King Muir’s Flagship Fund. USA equally allocates its portfolio assets across five managers: Matrix Asset Advisors, Pzena Investment Management, Schneider Capital Management, Cornerstone Capital Management, and TCW Investment Management. From an income perspective, USA is very attractive, yielding a 6.61% dividend annually. In effect, USA provides investors the opportunity to employ five money managers and receive a healthy dividend all for the price of one NYSE listed security currently trading at a 14% discount to its NAV.
As markets move, Exchange-Traded Funds are generally the first to respond, causing the market price of Closed-End Funds to experience a lag in responding to market movement. This means that when markets quickly fall, the discounts of Closed-End Funds narrow, and when markets quickly rise the discounts widen. We have seen the latter of the two scenarios play out over the last two weeks. As a result, the lull in Closed-End Fund volume has pushed USA to its widest discount in a little over three years. 25 years of experience trading Closed-End Funds has taught us to believe that when discounts become really wide, good things generally tend to happen. The Bloomberg chart below illustrates the widening of USA’s discount, but more importantly the volatility of USA’s discount.
A key reason we especially like USA is its discount volatility. As you can see in the chart above, USA’s discount frequently widens and narrows by as much as 2% over a one to two week holding period. Our core strategy is to build our positions as discounts widen, and sell them as discounts narrow. Given the volatility of its discount, USA is a great candidate for harvesting alpha by way of King Muir’s rolling discount strategy.
Lastly, as we build our positions in closed-end funds we hedge our market exposure with strategic options positions. For example, as we increase our USA position, we buy puts on SPY, the SPDR S&P 500 ETF. These puts act as insurance policies whereby we become short the S&P 500 and make money in a falling market, offsetting the losses incurred by our long USA position. The chart below illustrates why we can effectively hedge our USA position with SPY – the two securities are 97% correlated, meaning both move in lockstep in the same direction.
As always, please reach out if you have any questions regarding our funds or would like more information regarding anything mentioned in this letter.
The King Muir Management Team
150 N. Michigan Ave. Suite 1250
Chicago, IL 60601
IMPORTANT INFORMATION: This is not an offering or the solicitation of an offer to purchase any interest in the KGR Series LLC of funds (The Fund). Any such offer will only be made to qualified investors by means of a confidential private placement memorandum, operating agreement, and subscription documents, and only in those jurisdictions where permitted by law. The performance data contained herein represent the actual performance of The Fund net of all fees and expenses. During the time period shown, The Fund used only those investment strategies disclosed in The Fund’s Confidential Private Placement Memorandum. Data presented from January 2005 to May 2006 consist of separately managed accounts managed by Kenneth G Rosenbach. May 2006 to August 2011 consists of BircKennBach, L.P (BKB ), BKB II, BKB III and BKB IV. In September 2011, KGR Capital Management, LLC acquired the proprietary trading strategy and personnel from BKB limited partnerships. All comparisons to indices are for informational purposes only. The Fund’s investment program does not mirror the index and the volatility of the Fund’s investment program may be materially different. All performance figures shown include the reinvestment of any dividends and other earnings, as appropriate. No assurance can be given that the investment objective will be achieved or that an investor will receive a return of all or part of their investment. As with any investment there is the potential that for gains and the possibility of loss. Firm or Strategy AUM represents regulatory assets under management. Actual individual performance results may differ from composite returns.
The percentage returns shown are calculated for the Partnerships as a whole. The percentage for an individual investor may vary from these percentages based upon different management fees and incentive arrangements and the timing of capital contributions and withdrawals. Performance statistics are presented herein net of fees and allocations; may be subject to change; and are qualified in their entirety by reference to the Fund's audited financial statements. Past performance is not indicative of future returns.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.