Successfully trading closed-end funds does not require a doctorate in higher math, but, as the old joke goes,
it doesn't hurt
After retiring as chief of mathematical research for the National Security Agency in 1995, Richard Shaker started Shaker Financial Services in order to focus his quant skills on trading closed-end funds. And while Masters of the Universe like New York Mayor Mike Bloomberg and New Jersey Sen. John Corzine have traditionally used their banking bundles to launch second careers in politics, Shaker says his reverse course from Washington to Wall Street has proven both intellectually and financially rewarding.
Based in Annapolis, Md., Shaker Financial Services manages more than $45 million in assets for high net-worth investors, up from $3 million in 1995 and $24 million in 2002.
asked Shaker for a quick seminar on the often misunderstood topic of closed-end funds.
What are the advantages/disadvantages of closed-end funds vs. open-end mutual funds?
The advantage in buying an open-end fund is knowing that no matter what day you choose to sell, your payout will equal net asset value. An advantage for long-term investors in buying closed-end funds is the ability to buy at a discount. Dividends, capital gain distributions and tenders are paid at 100% on the dollar, whereas the purchase cost was at less than 100% on the dollar.
For a trader, the advantage is to be able to buy the fund when, temporarily, the discount is greater than it typically is, or when the premium is less. This is because there is an empirical proposition that a fund's discount will revert to its average. There are some studies that challenge this principle, but I believe it to be true from experience and, indeed, it is the basis for most of my success as a money manager.
Those are the most important advantages as far as I'm concerned. Traditional ones given are, one, that a closed-end fund will not suffer from redemptions when markets are weak, causing the manager to sell at panic prices. And, two, that a small-cap closed-end fund will not suffer from getting too large, diluting the managers' ability to pick a focused portfolio of his best ideas.
Why do some closed-end funds trade at such big discounts? Or premiums?
There are academic treatises on this, but I find them confusing and contradictory. Some argue that there should be a discount because the holder has no way to force realization of asset value. And it is sometimes argued that imbedded capital gains should make the fund less attractive to a long-term holder and lead to a discount.
Conversely, tax-loss carry-forwards should make the fund more attractive to a long-term holder and lead to a premium. However, in truth, the opposite happens, because good-performing funds gain a reputation for their managers, conversely for the poor performers.
is an interesting example of a fund with large tax-loss carry-forwards that tends to have the highest discount to net asset value of any domestic large-cap fund. Ironically, Tri-Continental has changed its manager and has been an above-average performer recently. It continues to be punished, however, for its sins of the past.
Sentiment tends to affect discounts. Since investing in India became trendy, the
has gone from a 20% discount to a 5%-10% premium. I have noticed a tendency for the relative discount of sector funds to widen when sectors have fallen out of favor.
What is your trading strategy?
Although we look at the full spectrum of average discounts over all periods of time, we find the three-week moving average to be the best indicator of what we should buy for a short-term trade. So every morning, we tend to buy those whose discounts are significantly below their 15-day average, and, conversely, sell our holdings whose discounts are significantly above.
Although we have no fixed period that we hold new purchases, our median holding period is two to three weeks, but we do manage to hatch some good performers into long-term holdings. We try to maintain a consistent total portfolio sector allocation in domestic equity, emerging market equity, and various kinds of fixed income. We also have positions in closed-end funds where we expect activism to be successful, are planning to open-end or liquidate, or have a fixed schedule to open-end or liquidate.
How does the use of leverage affect closed-end funds? What are the dangers of using closed-end funds?
Answering the second question first, there is a tendency for discounts to widen in a crash, which results in a double whammy on the downside. This is the most extreme example of a tendency for sentiment to affect the discount, which tends to make the funds slightly more volatile than their underlying assets.
Some closed-end funds issue preferred shares, which are a way for them to essentially buy on margin. This adds to volatility, which I don't personally have a problem with because you just buy less than you otherwise would.
However, in March, investors began to have increased fears -- which turned out to be valid -- that
tightening might go farther than previously thought. Leveraged closed-end income funds had been sporting significantly greater dividends than the dividends of their bond holdings, thanks to the sharp yield curve. As short-term rates rose faster than long-term rates, the dividends of these funds actually dropped. This caused a double whammy, in that not only did net asset values drop, but so did dividend yields, causing discounts to widen.
Although our "switching" still added value, March 2005 was one of my worst months relative to the market in my 10-year-plus history of closed-end fund trading. It was the primary reason why, year to date, we are only up 5%, versus a 2% total return in the
. We usually outperform the market much more than this.
How is the growing popularity of ETFs affecting the closed-end fund business?
I believe, in a subtle way, it is encouraging managers to liquidate closed-end funds, and lessening the number of new closed-end funds. Closed-end funds are an old-fashioned vehicle, but it's a game well worth playing, even if some people say it's in the eighth inning.
Why are people saying the game is almost over?
There is a recent, interesting development that shows that closed-end funds may be entering the ninth inning of play. A number of the older, larger closed end funds,
Salomon Brothers Fund
and Tri-Continental have been long considered immune from the activists because of their size.
However, a number of activists have recently been taking advantage of the need for
to get a positive vote from shareholders to transfer the management contract from
, have begun pressuring the first of these funds to enhance shareholder value. Success by these activists could encourage other activists, Carl Icahn wannabees, and hedge funds with lots of money looking for things to do, to set their sights on all these funds. But remember, in this game, the end can be very profitable, even for small investors who choose to shadow the big fish.