Closed-End Fund Investing: Buying Assets Below Net Asset Value

During their recent episode, Tobias Carlisle and Tim Melvin discussed Closed-End Fund Investing: Buying Assets Below Net Asset Value. Here's an excerpt from the episode:

[Tim] I love closed-end funds. We started buying closed-end funds in the 90s in the aftermath of Drexel Burnham, because I worked for Dean Witter. And Dean Witter back then, they loved closed-end funds.

Closed-end funds, you could pitch them as IPOs, because closed-end funds are not like normal mutual funds. When you buy a fund from Fidelity, you’re transacting with the fund, you buy and sell through the fund. In a closed-end fund, there’s an IPO, and then it trades on the exchange, just like a regular stock or bond.

So Dean Witter loved them, because you could pitch those and there was no direct commission, 7% sales charge, mind you, built in internally, but no obvious commissions. And they did a lot of junk bond funds. So when Drexel blew up, so did the funds.

So the funds were sitting here and they had all these milk and underwritten junk bonds in them, and a bunch of first Boston stuff. But most of the loans were still performing. A lot of them were going to go out, but probably 75% of the market never defaulted.

So we’re getting 15% yields and paying a 20% discount on these closed-end funds. It was the no-brainer of the day and it worked out tremendously well. And we’ve seen dislocations like that, that occur in markets and it creates opportunity in closed-end funds.

Now, there’s a natural opportunity to a closed-end fund that I’ve always found attractive. Again, Fidelity, BlackRock, all of the major mutual fund companies, they advertise constantly on the financial networks, online, everywhere you look, there’s ads and advertising for this fund and that fund and this fund. There’s no marketing for closed-end funds.

There’s no natural aftermarket buyer because it trades on the exchange. So you can’t trade, you can fix your NAV every night. You know what it is, but you can’t change the market price.

You can’t fix that. So you become subject to the same psychological soup of the stock market that everybody else is. So when it’s popular, your fund will actually trade at a premium, more than the actual value of the stocks and bonds owned by the fund.

Most of the time you’ll trade at a small discount. Occasionally, you’ll trade in an above-average discount. That’s when it starts to get interesting because now we can step in and we can be buyers of these funds at a discount.

Over time, nature will eventually, market cycle will change and buyers will come in and then capital narrow by itself. I’m greedier than that. I want the discount.

I want the nice yield and I want an activist. And there’s a couple of them in the space. For years, the biggest player was Bulldog Investors.

That was Philip Goldstein. And Goldstein had a great backstory, had a partner that was an ex-Dean Whitter broker like myself. And so that was it.

But he was an engineer for the city of New York, worked on bridges and stuff around the city of New York. But his natural attraction to math bought him the closed end funds and he ended up running a successful hedge fund where they would buy these things at a discount. And then they’d go in and they’d go to the fund and say, look, we own a lot of your stock.

Classic activism, right? You need to do something to make this discount go away or we will launch a proxy fight. So what can the fund do?

Well, they can liquidate and give us back the cash. They don’t like to do that. Closed end funds are captive capital, right?

They’re permanent capital is the phrase that they like to use on Wall Street. Capital leaves a regular mutual fund. You don’t get fees on it anymore.

You raise a fixed amount in a closed end fund, you get fees on it forever. So they’re not going to liquidate it. They don’t want to do that.

So you can buy back stock. You can conduct a tender offer, which is the norm. We see a lot of those.

We just saw a couple of those in the industry. So generally speaking, we’re looking at a couple of ways of making money. One, the asset class turns around.

Like right now, if you’re buying into certain segments of the bond market and they lower rates in a couple of years, the asset class is going to turn around. B, the discount narrows or even goes to a premium. That’s driving the price up.

And then C, you’re collecting a dividend yield.