Adviser Dan Weiskopf writes that in this world of low fees, closed-end funds are not typically thought of as an appropriate retirement account strategy. But as as an alternative to high yield or as a component to an alternative type of strategy, here's a fund that looks very interesting.
By Dan Weiskopf
Historic deep discounts in the closed-end fund space have created a value opportunity, but due diligence to implement a fund-of-funds approach is a full-time job, requires tools, and is ripe for activism.
Moreover, scalability to affect change where needed entails an activist approach, and in my judgment, this $270 billion investment wrapper is ripe for disruption. An activist approach to an underperforming corporation is not recent news, but in the "White Shoe" world of asset management, activism is rare.
However, Saba Capital, with over $1.5 billion in assets, now offers an ETF, the SABA Closed-End Fund ETF, to investors. Put simply, SABA's $26 million in assets under management (AUM) in this ETF is only about 18 months new, but the firm's track record is long and deep in the space.
Fee-sensitive investors looking at traditional metrics may be turned off by the minimal opportunity for capital appreciation in this fund, but this is the wrong way to look at the opportunity. Investors should rather look at this fund as an alternative sleeve, arguably measuring the outcome of this fund as a total return solution. The goal of the fund is to capture dividend income from the holdings in the fund, which is currently at approximately 8.5%, while also identifying those funds which are trading at an opportunistic discount that ultimately could be closed through some activist pursuits.
Noteworthy is the fact that SABA's structure takes pains to hedge out some of the risk associated with higher interest rates. They do this by carrying a 20% to 30% short in the Treasury 30-Year ETF. This means that there is an additional cost embedded in this ETF, but investors need to know that this cost does not go to pay SABA management. Rather, it is a pass-through cost that is associated with the wrapper's structure that, in a rising rate environment, should pay off, but as a hedge will also be a drag on returns if rates do not rise.
Three factors exist that make this hedge structurally smart in my judgment. First, while there is real risk of a recession at some point, the reality is that interest rates in the U.S. have probably bottomed after 30 years.
Second, (Call it a hunch, or simply a philosophy associated with economics 101) borrowers will ultimately have to pay more for the leverage they are taking. While the spread trade may be working to the advantage of the U.S. right now, at some point it could tilt the other way.
Third, assuming rates do go up, some of the closed-end funds owned in the ETF will bear higher rates costs. Borrowing by large firms can sometimes mask realities.
Ultimately, capital costs are a function of risk and capital allocation. As a result, this interest rate hedge is an important function of the value proposition that this fund provides and something that most investors could not or would not manage effectively.
At the end of the second quarter, assets in closed-end funds from the previous quarter were about $268 billion across 519 funds, down from $275 billion across 530 funds. A key benefit of the closed-end fund structure is the long-term capital that is designed to be patient with an investment mandate, i.e. the stated investment policy.
As a result, the closed-end fund discount may widen when more people are less patient with the mandates, which leaves remaining holders with the burden of high fees and leverage. Arguably ETF alternatives have also contributed to the discount. After all, there are often unleveraged ETF alternatives that are less expensive.
This is where capitalism shines and, according to a Harvard Business School case study, so does SABA Capital. As one of the biggest buyers in the closed-end fund industry, with over $700 million in dedicated closed-end fund AUM, SABA is set up in a natural activist role.
Without embarrassing anyone, the SABA team can make the call that every closed-end fund manager dreads to receive. Hypothetically, the conversation probably goes something like this, "Portfolio Manager, what have you done for me lately and what are you going to do to narrow the gap to net asset value? There are a lot of alternatives to your fund and the fee, leverage, and lack of performance need to be addressed. I know you like your job, but let's be fair. The discount could be narrowed easily through a conversion, buy back, or liquidation. Please consider some action over the next few weeks or months - these fees are deteriorating the NAV. You know us - we are not going away - negative headlines are not good for your other funds or your overall brand value."
To be clear: In this world of low fees, closed-end funds are not typically thought of as an appropriate retirement account strategy. However, investors have different stages of retirement and, as an alternative to high yield or as a component to an alternative type of strategy, this fund looks interesting.
The monthly dividend yield is almost 8% and it has an embedded interest rate hedge. In addition, the value proposition of playing an activist role in narrowing the 11% gap on its individual holdings offers some capital appreciation upside.
Fees paid to SABA at the fund level are 1.1%, but outside fees paid to the managers of the closed-end funds they invest in add an additional 1.45% or so to the overall mix which aggregate to 2.55%. Then again, such a fee may appear cheap compared to the usual 2/20% activist hedge fund.
About the author: Dan Weiskopf is a member of the Investment Committee at Toroso Asset Management and the ETF Strategist for the ETF Think Tank. The Tank provides due diligence tools to advisers looking for differentiated solutions. Dan Weiskopf has over 30 years of buy-side experience and has been focused on ETFs for over 15 years. Prior to joining Toroso, he managed portfolios under the name Access ETF Solutions (2013-2018) and Global ETF Strategies (2008-2013). Prior to focusing on ETFs he founded MH Capital Partners (1995-2003), a long-short small cap hedge fund and worked at American Diversified Enterprises, a family office affiliated with Allen & Company Fiduciaries. Financial professionals can sign up for the Tank here, or reach out directly to Dan Weiskopf at Dweiskopf@Torosoinv.com. It is important that all readers review the below disclosure and manage their own risk. These comments should not be considered investment advice. Please read this critical disclosure.
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