Managed Management: A Conversation With A Closed-End Fund Advisor, Pt. 1
John Cole Scott is the Chief Investment Officer and Chief Compliance Officer for Closed-End Fund Advisors, an investment firm that specializes in discretionary management of closed-end fund assets. Recently, CEF Advisors launched 26 daily-priced indexes covering the closed-end fund and business development company landscape.
Marketfy Maven Tim Melvin recently spoke with Cole about CEF Advisors initiatives in the closed-end fund environment and how managing a CEF portfolio is unlike any other investment strategy.
Below is part one of their interview, edited for length and clarity. You can find part two here.
Tim Melvin: We're talking today with John Cole Scott of CEF Advisors. You're a registered investment advisory firm up in Richmond, Virginia, is that correct?
John Cole Scott: We are. We're based in Richmond, Virginia, but we used to be based in Santa Barbara, California. We bought a distressed firm and took it to Richmond in '97, after we bought full control, so we've owned it almost 20 years.
Melvin: And you guys specialize primarily in closed-end funds, correct?
Scott: Yes. So we focus on closed-end funds. We also include business development companies, or BDCs, which are technically closed-ended management companies.
Melvin: What drew you to the closed-end fund universe? Because it's very, a selective kind of specialty, not well-known segment of the investment world.
Scott: My answer is always, if it was easy, everyone would be doing it. But I happened to be born owning closed-end funds because my father and his best friend bought control of venture equity fund in 1970. We started in '72 from a broken IPO in 1968 called Diebold Capital. His buddy bought a third of the stock over time, and my family owned another 10 or 15 percent. But family friends owned a bunch, and we bought control of this fund and my dad was a board member.
I came in as a very bright-eyed, bushy-tailed 22-year-old college kid to help. And what I've done since 2001 when I joined him, was...Well in '08, we built the data side of the business[...]Other data files were fine, but they weren't niche-y, they weren't nimble, they didn't define things the way I wanted them defined, and so the only way to make it yours is to make it yours.
[We} have been very pleased in the data business for five years, and we've grown from two portfolio models when I joined him now to, it depends on how you define it, 14 diversified models with the ability for them to be tax-optimized or not, and then two sector models[...]We have four BDC model portfolios right now, whether you care about different attributes we can bring out, and then we have two muni models, basically one that yields more with more duration risk, one that yields less with less duration risk.
It's an interesting animal, we do data, we do a newsletter, we do consulting, not scalable, but enjoyable projects, and we have a unit investment trust with a partner firm in the BDC space, where we've raised about a quarter billion dollars in a UIT wrapper through most of the advisor channel, and that was a great partnership to leverage our data[...]Our expectations were about less than half that, so I was very pleased in the last 28 months to hit that number.
Melvin: It sounds like you guys have been real active in the space for a very long time now. And imagine if you're still here, you've had some deep measure of success over the years. What do you see going on in the closed-end fund markets today, almost eight years into a bull market and a lot of interest rate uncertainty.
Scott: Closed-end funds have 12 main sectors, roughly half are equity, so equity sectors are REITs, are MLPs, there's US equity, there's international equity, there's covered call funds[...]and you've got options. On the bonds side, you've got senior loan funds and high yield bond funds, and BDCs, and muni bond funds. And we would bucket preferred equity technically as a bond investment, if you know preferreds. So you've got 12 major buckets.
An equal weight yield right now in the sector is just under 8 percent If you take the seven most liquid funds in those 12 sectors, they're trading right now at about three discount, and their five-year discount is normally 3.7. So they're not expensive or cheap, but they were trading at like maybe an eight discount a year ago. So discounts have narrowed from pretty much all the sectors as a whole in the last five years, but we're not expensive.
What we find is that there really is only duration risk focused in two buckets: preferred equity, because that's the way preferred equity trades, on duration risk; and the muni bond side, where you're able to get five in change yields federally tax-free, but a duration is 10, because you're levered 30 percent and you're buying longer bonds.
There's not many short-term and intermediate bond funds in the space, not many high-yield bond funds. Usually, you take longer bonds. You take 20-year maturities and leverage them 30 percent, and you yield five and a half, and your duration is 10.
Some people think a closed-end bond fund is a very close replacement to a bond. But there's a couple of differences[...]The bond fund has either taxable bonds or tax-free; it doesn't really matter[...]a closed-end fund is a fixed capital block of money that has a market price that trades on the stock exchange. So if I'm a portfolio manager at a closed-end fund with $1 billion of assets, I have a $10 net asset value, but I might trade it at $9 stock price, at $10.50, but that doesn't change my work as the manager. That's how you buy it, that's how you sell it.
So you have the actual guts inside of a fund, like an open-end fund wrapper type feel, but you trade on the market, so if people get excited or panicked, the stock price can move 3 to 5 percent on good or bad news. And while that's not crazy movement[...]open-end funds don't move 3 percent because it was quoted in the paper. There's an interesting dynamic with a bond fund where the guts are bonds, where they're generally more secure than equities, a good part of many retirement portfolios, but they trade as equities, so you have to remember it's an equity that derives its value from bonds.
The volatility is interesting, because[...]a prospect comes to our firm and says, "Maybe I want to hire you for one of our products, or maybe you want to do a consulting deal," or "Maybe I want to buy your data and do it myself." I go, "Did you own closed-end funds the last time they got kicked in the knees?" And if they say yes, "Okay. How did you handle your portfolio in that period of time? Did you go to cash and then sit on your hands and cry? Or did you look for stupid, cheap things and did you buy up?" And if you know the closed-end funds can be dislocated irrationally[...]There are three or four premiums, so literally there's a 30 percent difference between panic and optimism, independent of the manager's work. Obviously, if a sector sucks, discounts tend to widen. And if a sector's well-performing, it tends to narrow, but they don't have to work that way.
Melvin: Having said all that, I have to ask, do you see any irrational dislocations right now?
Scott: I would say the sectors that are still cheap...This year we've decided a better way to help prospects, clients, peers, press, look at our sectors, we did a bunch of indices. So I'm going to say, we have a real estate index that right now is at a 10.9 discount, which is normal for the last three years, but wide for the last 10. So the REIT discounts are wider than normal, not expensive. International stock funds are at a 12 discount, five-year average is 10. So little bit of extra alpha potential in the international side. The MLP discounts, the 10-year average is right around an asset value, they're at about three discount. So there's some sectors where you got 2, 3, 4 percent of extra potential discount compression than a 10-year average. And remember, usually at some point, things are above a 10-year average, they don't always stay there. So I would say those sectors are very positive.
If we had spoke 60 days ago, I would have said BDCs were cheap. But now they're trading as average seven premium which is normal, is basically their average number in a 10-year basis. So they're now average price. So there are opportunities there in MLPs, in REIT funds, in international as a whole group.
And then there are some individual funds, we have to dig through the layers. I always like to say, "We try to find funds that are a little bit broken, and then offset their weaknesses with a strength." We build a portfolio. When you come to us, or we think most people would get a portfolio closed-end funds, we give you 20, probably 20 to 35 closed-end funds, depends on the objectives, and each one plays a role in the portfolio, whether it's to add income or to lower beta.
So, I'm looking at the portfolio and I'm deciding which pieces offset each other. No investment's perfect. No portfolio's perfect. No fund's perfect. But we try to take what's wrong with one fund and offset that with what's right with another. So the overall portfolio is a team of investments working you towards a goal. Closed-end fund is not a stock, it's a portfolio itself, so you're trying to take the paint on your palette and paint a picture.
Melvin: So that's much more of a portfolio combined, everything working together approach, rather than just trying to riffle out some individual funds.
Scott: I'd say it's interesting; a closed-end fund can be perfectly managed and overpriced, and I would never buy it. And I would say the manager is the smartest, the brightest, the fund sponsor gives me the best data, they get the cheapest leverage[...]There can be a fund that's only average, but if it's trading wider than average discounts, I maybe can make up 2 to 4 percent of alpha, and so who cares if the net asset value is performing 50 basis points worse?
It's balancing the guts, the manager, the sector, the portfolio work with the wrapper, which is technically run by the sponsor, the board of directors, the dividend policy, the corporate actions. If we're going to do a rights offering or a secondary to grow the capital, if we're going to do a tender offer to shrink the capital, those aren't the manager's work, that's the structure; that's the discount. Do activists target these funds?
Click here for part two of Tim Melvin's interview with John Cole Scott in which they discuss the role of activist investors and business development companies in building a closed-end fund portfolio.
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