Eric Boughton Of Matisse Capital Talks How To Find Value In Close Ended Funds Trading Below NAV

Eric Boughton, the Chief Analyst at Matisse Capital talks about CEFs and explains why they could be an integral part of your portfolio. He also explains Matisse Capital's position in Pershing Square, the hedge fund managed by Bill Ackman.

Q1 hedge fund letters, conference, scoops etc


Eric Boughton of Matisse Capital Talks Finding Value in Close Ended Funds

Transcript

Josh: Welcome to today’s podcast. We have a special guest in the studio today named Eric Boughton. Eric is the chief analyst of Matisse Capital and he’s here today to explain how closed ends funds of CEFs can help strengthen your investment portfolio. Eric, welcome to the show. Can you take just a minute or two and tell us about yourself?

Eric: Well, thank you, Josh, for having me on. I appreciate Value Walk giving this opportunity. I have been here at Matisse Capital since 2006, as portfolio manager and analyst for our closed ends funds strategy, which I’m going to talk about in detail. Prior to that, I was at first source investment advisors in South End Indiana, where I was the portfolio manager and analyst for a small cap mutual fund. I graduated in 1997 from the university of Huston with a Bachelor of Science and mathematics, applied analysis. I have my CFA, I’m a CFA holder. I’m really excited to talk about closed end funds.

Josh: Great. That’s what we’re here to do, so we’ll just go ahead and jump right in. In its simplest terms, what is a CEF and how does it work?

Eric: Well, you asked for simple terms, I’m not really much of a specialist in simple terms, but I will say that the clear summary is that a closed end fund is a mutual fund that trades like a stock. Most people know that a mutual fund is an investment company run by a professional manager that owns a diversified collection of stocks and bonds. Of course, a stock is fractional ownership in an operating company, like Apple. Closed end funds combine those two concepts in one neat package.

The closed end part of the name distinguishes them from their more well-known open-end brother, and it references the fact that once shares of the closed end fund are issued in an IPO process, just like a stock, the issuance is closed, no more shares can be issued. Open end funds on the other hand, stand ready to issue new shares every day.

When you buy a closed end fund, you’re buying an investment company, but just like when you buy share of Apple, you’re actually buying from another investor. Whereas, when you buy an open-end fund, you’re buying the shares from the fund company, so you’re actually giving the fund company fresh money to manage.

Josh: Okay, that makes pretty good sense. How long have CEFs been around?

Eric: That’s a great question. Closed end funds actually go back farther than open end funds. The first open end fund came out in the 1920s, but closed end funds go back well into the 19th century. In fact, some of the closed end funds that were issued in the 20s and 30s are still around today.

Josh: Interesting. These have been around for a long time and they’re very well established.

Eric: Exactly.

Josh: Well, how are CEFs similar to and yet different from other mutual fund investments? Why buy a CEF over a standard mutual fund?

Eric: Actually, closed end funds are fairly similar to open end funds in a lot of ways, they’re both diversified investment portfolios. You can choose between a number of different investment styles. Now, there are hundreds of closed end funds, some invest in U.S. stocks, foreign stocks, the energy sector, bonds, foreign bonds, municipal bonds, global balanced. You name it. They’re also fairly similar in terms of diversification and risk.

A closed end fund, just like an open-end fund will typically own hundreds or even thousands of securities, so the risk that you face in a closed end fund is simple the market or the sector risk, in the case of a sector fund. It’s even the case that many of the professional investment firms that run closed end funds, such as Nuveen, Black Rock, etc., also run open end funds. However, there are these four key differences between closed end funds and open-end funds.

One of the key things and the key reason that many people buy closed end funds is that most of them pay regular cash distributions to their shareholders, either monthly or quarterly. Many funds in fact make these payments regardless of the income or capital gains that are generated within the portfolios, just like many stocks will pay steady dividends regardless of fluctuations in their probability. That’s one key difference is steady cash. Another difference is that sense they don’t have to worry about shareholder redemptions. The closed end funds can stay fully invested all the time and they can own somewhat fewer liquid holdings than an open-end fund can.

That can be a benefit to their long-term returns. A third related difference is that since they don’t have to hold cash to pay for redeeming shareholders, closed end funds can also utilize structural leverage in order to enhance their returns. Most fixed income closed end funds in fact carry 30 to 40 percent leverage, which is the FCC maximum. It should be noted, this is a benefit in rising markets, but of course, we’ll compound losses in falling markets.

The fourth difference, and this is a key difference between open-end funds and closed end funds, while investors in open-end funds buy and sell their funds at NAV, an investor in a closed end fund will buy and sell at the fund’s trading price throughout the day. That could be quite difference from NAV. Most closed end funds, most of the time, trade at discounts to their NAV.

Josh: Okay. You’re going to have to define that one for us. What does the term discount to NAV mean? How is it beneficial to know a particular fund’s discount to NAV?

Eric: Great. Thank you for stopping me on this critical topic. What we at Matisse have discovered is that more than over a decade of managing closed end fund portfolios is that the discount to NAV is the single most important thing to take into account when you’re making a buy or sell decision, it dwarfs every other factor. We better know what that is. NAV. NAV is short for net asset value. Every day both open-end funds and closed end funds calculate the value of their underlying holdings, and they divide by the number of shares that they have outstanding and they report the result out to various pricing services as NAV.

Just as a simple example, suppose you have fund XYZ, it owned one share of Apple. XYZ had issues ten shares to its own investors. On April 4th, Apple stock closed at $195.69. XYZ would report a daily net asset value of just that divided by ten. $19.57. On April 5th, with Apple stock up to $197.00, XYZ would of course report an increase in its NAV to $19.70. If that was an open-end fund, if XYZ was an open-end fund and you put in an order to buy it on April 4th, you would pay $19.57, you would just pay the NAV. However, if XYZ was a closed end fund, you would be purchasing it in the open market on April 4th. It might be trading at quite a different price. For example, maybe it’s trading at $17.61. That would be a ten percent discount to that NAV. Now, a key part of this is that if you then went to sell XYZ the next day, even though Apple stock was up, that XYZ might not be up. In fact, the discount to NAV on the fund might widen and you might take a loss on it.

Josh: That doesn’t sound very appealing. Why would anybody want to lose money in a rising market? It sounds like CEFs are kind of a suckers’ bet.

SORRY!

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