Market Still Wide Open for Closed-end Funds

NEW YORK (TheStreet) -- Closed-end funds suffered more than common stocks during the May flash crash, but have bounced back with gusto, says Rob Shaker, co-manager of Shaker Financial Services.

CEF's are tricky to trade, and few do it better than Shaker Financial Services. Based in Annapolis, Md., Shaker and his father -- who, by the way, used to be the chief of mathematical research for the National Security Agency -- oversee $90 million in assets, employing various closed-end fund trading strategies, most notably discount mean reversion. Shaker's composite managed accounts were up 15% for the year as of Tuesday, compared with the S&P 500, which returned just below 2% with dividends reinvested. Over the past five years, the Shaker portfolio has returned 11.7% on an annualized basis, far outpacing the S&P's 0.3% return.

Rob Shaker spoke with TheStreet about the current state of the CEF world.

How would you define your particular niche in the closed-end fund world?

Shaker: Generally speaking, we refer to our core strategy as "discount capture." We give our investors a diversified portfolio of CEFs, carefully selected in the hope that the discounts of our selected funds will narrow. Once these discounts narrow, we rotate out of these funds into others that we believe are inefficiently priced. When successful, this strategy provides our clients with a return over and above the net asset value return of the funds, creating our source of alpha.

What is the current state of CEFs? On the whole, where are discounts?

Shaker: Discounts have continued a steady recovery from their historic November 2008 lows. Except for a slight hiccup in May of this year during the European debt crisis, discounts in general have narrowed and are back to mid-2007 levels. In fact, the rather steady recovery from even the May widening presented a wonderful opportunity for discount traders to bargain hunt. Even though discounts have reached these levels, we do not feel that CEF discounts are by any means overly narrow. We believe that there are still wonderful opportunities for discount capture.

Have you changed your strategy in light of the overall discount recovery?

Shaker: At SFS, we have always preferred purchasing funds with large discounts, both because of downside protection and the possibility of a windfall profit if there is activism. However, recently we have become increasingly active in smaller discount CEFs. We have found that there are a number of funds that swing from small discounts to small premiums, back and forth, rapidly. We call these funds "fliers" not in the sense that they have large risk and large reward profiles, but due to their rapid movement between discount and premium.

Examples of funds which have been making quite rapid movements in 2010 include the Gabelli Global Utility and Income Trust ( GLU), Aberdeen Global Income Fund ( FCO) and the Eaton Vance Tax-Managed Diversified Equity Income Fund ( ETY). The Delaware boys, Delaware Investments Dividend & Income Fund ( DDF) and Delaware Investments Global Dividend & Income Fund ( DGF), have also been active, but they are less liquid and consequently harder to trade.

Our focus on so-called fliers has been especially keen in sectors that have recovered the strongest, some to the point in which the vast majority of funds are now premiums. A great example of this is high-yield bond funds. Of the 29 we track, 21 are at premiums, and the average is a premium of 5% versus a 1% discount a year ago. Some have suggested avoiding this sector as overdone, but we believe there have still been opportunities to capture discounts in names like the Western Asset High Income Opportunity Fund ( HIO), BlackRock Senior High Income Fund ( ARK) and Putnam High Income Securities Fund ( PCF).

Do you look for anything other than the size of the discount when you make a purchase decision?

Shaker: Probably the most significant change that has impacted our day-to-day trading philosophy has been a behavioral change in the manner in which large sellers liquidate individual positions. At SFS, we are a firm believer that large sellers can quickly create an actionable inefficiency in the discount of a particular fund. This is especially true in those funds that typically have low volumes. So if we see a seller exiting a position for a few days in a row in a big way, it's a good purchase signal for us as well.

What are you seeing on the activist front?

Shaker: Recently, there has been a pickup in activism and many have been successful in open-ending or liquidating funds. We are, of course, happy about this and grateful to the activists, not only because one of our strategies has been to anticipate these events, but also because we believe that this action helps provide downside protection to all CEFs.

-- Written by Gregg Greenberg in New York

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