Relative Value in Closed-End Funds
Closed-end funds have the ability to trade at premiums or discounts to their net
asset value, and allow an investor to build a relative value portfolio that delivers
both capital appreciation and current income. Erik Herzfeld explains how the
Virtus Herzfeld Fund invests in well-managed closed-end funds that trade at a
discount and are likely to increase their net asset value.
What is the history of your company and the Virtus Herzfeld Fund?
The Virtus Herzfeld Fund was launched on September 5, 2012 and specializes in a narrow field:
investing in closed-end funds, or opportunities afforded by the Investment Company Act of 1940. Because
closed-end funds have the ability to trade at premiums or discounts to their net asset value (NAV), they
allow us to build a relative value portfolio that seeks to deliver both capital appreciation and current income.
Erik M. Herzfeld
We understand the closed-end space quite well. Our firm, Thomas J. Herzfeld Advisors, Inc., has had this
same singular focus since it was founded by my father in 1984. Prior to the launch of the mutual fund, we
offered retail investors direct access to our closed-end fund expertise only through separately managed
accounts which require a high minimum investment. With the Virtus Herzfeld Fund, we extend access to a
greater number of retail investors.
Erik Herzfeld is responsible for the trading
and portfolio management activities of
Thomas J. Herzfeld Advisors, Inc., an
investment management firm specializing
in closed-end fund research, analysis, and
investment since 1984.
How do you define your investment philosophy?
Mr. Herzfeld is co-portfolio manager of The
Herzfeld Caribbean Basin Fund, the first
closed-end fund to invest in the Caribbean
region (NASDAQ: CUBA). Since 2012, he
also serves as co-portfolio manager of the
Virtus Herzfeld Fund, an open-end mutual
fund subadvised by Herzfeld Advisors for
Virtus Investment Partners.
Back in the 1930s, Charles Keane, publisher at the time of perhaps the largest circulating market
letter, argued that closed-end funds could never trade at a discount because they have professional
management and that has perceived value. But, in fact, most closed-end funds do trade at discounts, and
this is key to our philosophy: because closed-end funds are able to trade at discounts to their liquidation
value, at some point they will trade at discounts.
Using this mentality, we aim to build a flexible portfolio that is balanced and has all the hallmarks of
relative value. We do not have targets for yield or discount; we simply increase our investment level as
opportunities present themselves.
With many closed-end funds, discounts persist for years; these are not investments we find attractive.
For a position to be included in the portfolio, there must be a catalyst that will drive it back to par – back to
its NAV. When there is value to be had, the discount will narrow, so it is crucial to understand what is driving
the price rather than just buying anything that is at a wide discount.
Often discounts occur because of a particular type of environment, like the low interest rate climate we
have been in for some time. Since 2010, yield has become dominant and is something that drives a closedend fund’s discount to narrow. By definition, fixed-income closed-end funds can borrow at very low rates –
LIBOR plus 70 basis points. This ability to borrow at low rates and invest in bonds yielding higher rates
allows the fund to deliver a higher dividend rate.
Our objective is to not merely find discounted closed-end funds, but ones which are well run, where
the portfolio manager can generate gains in NAV. We couple this with a timing process to buy funds at
an attractive discount. Buying a closed-end fund at a discount gives us the opportunity to make
money if nothing happens to its NAV, or even when it decreases, unlike a mutual fund where no money is
made if the NAV does not move, or if it goes down.
For instance, if a closed-end fund is purchased at a 10% discount and suddenly goes to a 5% discount,
we would still come out ahead even if the underlying NAV of the fund dropped a few percentage
points over that time period.
President and Portfolio Manager Thomas J. Herzfeld Advisors, Inc.
Mr. Herzfeld has over a decade of Wall
Street experience in the equity and currency
derivatives markets. Prior to joining Herzfeld
Advisors in 2007, he held quantitative
research and trading roles at both Lehman
Brothers and JPMorgan, where he served as
a vice president based in New York and Asia.
Mr. Herzfeld earned a B.A. in economics, with
a concentration in mathematics, from Johns
Hopkins University and an S.M. (M.B.A.) in
financial engineering from MIT Sloan School
of Management. He began his career in the
investment industry in 1998.
“Buying a closed-end fund at a discount
gives us the opportunity to make money if
nothing happens to its NAV or even when it
decreases, unlike a mutual fund where no
money is made if the NAV does not move,
or if it goes down.”
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What is your investment strategy and process?
Our investment strategy is based mainly on our deep understanding
of the roughly 600 closed-end funds in this space. A few of them have
actually been around since the 1920’s, and we have gotten to know them
quite well over the years.
Instead of using a cookie-cutter approach, ours is more finely honed – we
do more than merely read prospectuses. We know the funds’ boards and
how they work, how the investment managers work, and whether there is
high or low turnover, for example.
Our goal is to build a portfolio with diversified exposure. Though we do
not generally express a strong view regarding what the Federal Reserve
may potentially do, we do think about the type of environment the market
is in, considering whether it is risk-seeking or risk-averse. This is typically
exhibited through a fund’s discount or premium.
Closed-end funds have certain tax code advantages because any gains
can be offset with losses. In an Initial Public Offering (IPO), a closedend fund often goes to discount right at the start because certain fees go
into the launch; the IPO price starts in one place but will gravitate lower.
To get a sense for what is happening with tax-loss selling, we spend a lot
of time understanding the IPO market. Also, at the end of the year, seasonal
patterns make investing in the closed-end space interesting.
How does investing in closed-end funds differ from traditional
investing, and where do you look for opportunities?
Closed-end funds can lever themselves in several different ways,
including through lines of credit (LOCs) and preferred shares. Under the
Investment Company Act of 1940, the type of leverage a fund uses dictates
its asset coverage ratio throughout the life of the fund, establishing how
much of its assets must be maintained to cover liabilities.
The preferred shares of a closed-end fund differ from traditional
preferred shares, and probably are the least well understood of any of
our investments – at least in the stock market. The majority of investors
have not spent the time to understand these and are confused to
the point that perhaps it would be better to call preferred shares by a
different name.
Nonetheless, we benefit from this confusion. We are quite interested in
buying preferred shares as they represent a strong value. We understand
them, have significant holdings in them, and historically, our largest
position has been in the preferred shares of Oxford Lane Capital Corp. A
closed-end fund can issue a permanent security out of the balance sheet,
which is what Oxford Lane did. It had an IPO and came to market with a
coupon of 8.125% that expires in 2024, and a coupon of 7.5% that expires
in 2023. These were issued at a par of $25 and pay coupons monthly. At
expiration, we get back our $25 and all of our dividends. In actuality, these
are cumulative preferreds. Thus, if for some reason Oxford Lane missed a
dividend, it would have to pay it back in the end.
We think of preferred shares as fixed-income instruments and what attracts
us is the yield, because not a lot of investments offer this kind of yield.
When a traditional company like General Motors Company, Ford Motor
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Company, or Exxon Mobil Corporation issues a bond, it is only as good as
its balance sheet. If their business hits the skids, it will affect how the bonds
are going to trade.
Contrast that with a closed-end fund like Oxford Lane. Though its portfolio
is diversified, there is a common theme: it is loaning money. Its underlying
business is collateralized loan obligations (CLOs), and the firm’s
management team members are experts in these debt instruments. The
CLOs it buys are traditional corporate debt and senior loans.
The benefit we get by holding a preferred share in Oxford Lane is it gives
us a lien on the portfolio. Oxford Lane has a balance sheet, holdings, and
CLO instruments – and has to maintain an asset coverage ratio of 200%
because of the way the Investment Company Act of 1940 works.
We buy these preferred shares whenever they are under pressure, meaning
when they trade below par. If the common shares of the company end up
trading lower, there is a correlation and the preferred shares will also go
down. However, I think this happens because people do not understand
that if a closed-end fund hits its asset coverage ratio, it is mandatory that
the fund buy back shares or reduce its leverage. If the fund is trading at
$22 and suddenly hits its asset coverage ratio, there is upward pressure
on the preferred shares to go back to par because it will have to take those
shares off the market.
This happened in 2008 to similar closed-end funds when the stock market
was under duress. We were buying preferred shares at the discounted
liquidation value, and a few days later they were going to par because
the funds were required to reduce their leverage. Basically, we created a
put on the stock market by buying these preferred shares – they offer an
incredibly attractive yield and the lien is the portfolio itself. Most investors in
preferred shares do not price in this put option.
What is your portfolio construction process?
The Virtus Herzfeld Fund is widely diversified, with the single
biggest exposure being to Apple Inc. at roughly only 1%. Looking at
most equity investments, the risk exposure to any single name is closer
to 5% or 6%.
The Fund has hundreds of positions and its breakdown changes frequently.
At the time of this interview, current holdings are 27% preferred shares,
which also includes a bond; Eagle Point Credit Company Inc. has issued
a debt instrument which is a bit higher in the capital structure than its
preferred shares.
We like to keep extra cash on hand to be able to take advantage of buying
opportunities as they arise. Right now we have 20% of the portfolio in cash,
but that level has ranged from zero to as high as 25%.
The remaining half of the portfolio is in 27 closed-end fund stocks.
Though these change, approximately 10% are currently in the healthcare
space, where we have found attractive opportunities. Due to their cheap
valuations historically, we have been able to buy them at a discount.
In some cases, these funds have traded at double discounts, because
the market discounted the healthcare company and then discounted
the fund.
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For instance, Gilead Sciences, Inc. is one of the healthcare stocks held by closed-end funds in our
portfolio. Last year, the healthcare market was under pressure; more recently, with the increased price of
EpiPens, there has been avoidance of the sector by the investment community because of an impending
law change.
This has pushed the valuations for healthcare stocks to historically low levels. A lack of demand in the
underlying business translates to low demand for a closed-end fund that holds those stocks. As a result,
there is quite a bit of discounting going on. We are buying Gilead at a 10% discount to where it trades in
the market, and Gilead is probably already being discounted, trading at a P/E ratio of around 6.
We also have positions in fixed-income funds, in country funds including small positions in Japan and
some European exposure, and exposures to Master Limited Partnerships (MLPs).
Our benchmark is a 60/40 benchmark consisting of 60% MSCI All Country World Index and 40% Bloomberg
Barclays U.S. Aggregate Bond Index. Although having a benchmark is important to give a sense of how
the Virtus Herzfeld Fund is doing, it is probably the hardest thing to pinpoint. We simply try to achieve 500
to 600 basis points over inflation, which we feel is a healthy return.
Virtus Herzfeld Fund
Adviser
Subadviser
Symbol
Address
Virtus Investment Advisers
Thomas J. Herzfeld Advisors
VHFAX (Class A)
VHFIX (Class I)
100 Pearl Street, 9th Floor
Hartford, CT 06103
Phone
800-243-4361
Websitewww.virtus.com
Source: Company Documents
How do you define and manage risk?
Many people think risk is only about how much money can be lost, but to us, it is about volatility – how
much something can move. We look at risk as a statistical relationship, similar to a Sharpe Ratio or other
risk-adjusted standard deviation criteria. Every instrument has possible pros and cons along with some
type of investment trade-off – it is necessary to give something in order to get something.
For example, with the Oxford Lane preferred shares, we know we will not make 50%; however, we are
seeking to get 650 basis points over Treasuries for something that is good in terms of risk with a potentially
high Sharpe Ratio. Every bond has a lien through the company, or in this case, the lien is the portfolio itself.
Some of our other positions, like MLP funds, moved down last year, on average 50%. Because the risk/
reward potential is so much greater, the portfolio will not have 30% exposure to MLPs. The Sharpe Ratio
is simply not as attractive. The fact that we can potentially make 50% also means that we could lose
everything because of the high level of volatility associated with MLPs.
We are trying to find the best relative value. If we know we will get 7.5% in an Oxford Lane preferred stock
trade, why would we buy something else with greater risk for the same 7.5% reward? For instance, with an
oil exploration company, we would want to have a lot more reward.
Each day presents certain risk and reward opportunities. We rank them to see which offers the greatest
reward potential for the lowest amount of volatility. With fixed-income funds, it is easier to do the math, and
we use different criteria than we do for our equity funds. With equity funds, managing risk is more difficult
and requires that we spend more time on the analysis of the discount/premium relationship than on the
preferred shares. However, the reason equity funds are in the portfolio is because of the opportunities
they offer. In some environments, the Virtus Herzfeld Fund will have a much higher concentration of equity
holdings, and in others, more fixed income exposure.
Lately, yield has been the most important thing, so that is what we position ourselves around. Because
closed-end funds can actually lever themselves, a portfolio like ours can generate an attractive amount
of yield, especially through its fixed-income positions. Our due diligence gives us a good idea of what the
Virtus Herzfeld Fund’s distributions will be.
We are firm believers in balancing risk and reward. For us, managing risk is front and center. Unless there
is a worthy opportunity elsewhere, we want our money in cash – to us, cash is a call option on everything.
Just by holding it, we are paying the inflation rate of 2% a year – and we do so in order to add optionality
to the portfolio. Cash gives us the opportunity to buy everything at lower levels when the market sells off,
and this is a critical component to our strategy. Most mutual funds tend to run with very little cash – some
even have mandates to have no more than 3% cash. The Virtus Herzfeld Fund can be up to 100% in cash.
If we do not see an opportunity because everything is trading at a large premium, we are not forced to buy
something that could go down. T
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For more information, please
contact Virtus at 1.800.243.4361
or visit www.Virtus.com
TOP TEN HOLDINGS as of October 31, 2016:
Oxford Lane Capital Corp 8.125% Liquidation Pfd Shs Series 2024: 8.23%, Eagle Point Credit Company Inc. 7% Notes 2015-31.12.20:
8.21%, BlackRock Science & Technology Trust: 5.04%, MVC Capital Inc. (Doing Business as MVC Capital) 7 1/4% Notes 2013-15.1.23
Sr: 4.53%, Boulder Growth & Income Fund Inc.: 4.52%, Nexpoint Credit Strategies Fund: 4.09%, Tekla Healthcare Opportunities Fund:
4.03%, Oxford Lane Capital Corp 7 1/2% Term Cum Pfd Shs Series -2023-: 3.29%, Tortoise Pipeline & Energy Fund Inc.: 3.22%, Tekla
World Healthcare Fund: 3.05%
Holdings are subject to change and are provided solely for reference. This information is not intended as investment advice and should not be
considered as a recommendation to buy securities.
Sharpe Ratio: a statistic that measures the efficiency, or excess return per unit of risk, of a manager’s returns. It is calculated by taking the
portfolio’s annualized return, minus the annualized risk-free rate (typically the 30-Day T-Bill return), divided by the portfolio’s annualized standard
deviation. The greater the Sharpe Ratio, the better the portfolio’s risk adjusted return. Standard Deviation: measures variability of returns around
the average return for an investment portfolio. Higher standard deviation suggests greater risk. London Inter-Bank Offer Rate (LIBOR): the
interest rate that the banks charge each other for loans (usually in Eurodollars).
IMPORTANT RISK CONSIDERATIONS:
Closed-end Funds: Closed-end funds may trade at a discount from their net asset values, which may affect whether the fund will realize gains or
losses. They may also employ leverage, which may increase volatility. Equity Securities: The market price of equity securities may be adversely
affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance
that risk. Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer
of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest
rates, and this risk may be enhanced with longer-term maturities. Foreign & Emerging Markets: Investing internationally, especially in emerging
markets, involves additional risks such as currency, political, accounting, economic, and market risk. Fund of Funds: Because the fund can invest
in other funds, it indirectly bears its proportionate share of the operating expenses and management fees of the underlying fund(s). Prospectus:
For additional information on risks, please see the fund’s prospectus.
Please carefully consider a Fund’s investment objectives, risks, charges, and expenses before investing. For this
and other information about any Virtus mutual fund, contact your financial representative, call 1-800-243-4361 or
visit Virtus.com for a prospectus or summary prospectus. Read it carefully before investing.
Not all products or marketing materials are available at all firms.
Not insured by FDIC/NCUSIF or any federal government agency. No bank guarantee. Not a deposit. May lose value.
Mutual Funds distributed by VP Distributors, LLC member FINRA and subsidiary of Virtus Investment Partners, Inc.
5163 11-16 © 2016 Virtus Investment Partners, Inc.
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