Ticker Symbols

RNCIX (Class I) RNCOX (Class R)

Investment Advisor

RiverNorth Capital Management, LLC

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Timing Closed-End Fund Discounts for Alpha

Mar 6, 2020

RiverNorth Core Opportunity Fund

  • AUM

    $104 million

  • Inception Date

    Dec 27, 2006

  • Portfolio Holdings

     

  • Portfolio Turnover

     

Q: How did the fund evolve? What differentiates it from other mutual funds?

A: RiverNorth was founded as a traditional registered investment advisory firm. During the late 1990s and early 2000s, I was enamored with the inefficiency in the closed-end fund space. The space was mostly owned by retail investors, who were often buying and selling irrationally, based on fear and greed. That affected the premiums and the discounts in closed-end funds.

In 2004, we joined forces with Brian Schmucker, the founder of RiverNorth, to opportunistically trade closed-end funds for our separately managed accounts. In 2006, we established the fund because we saw the need for it. Although most financial advisors know that closed-end funds tend to trade inefficiently in the secondary market, they don’t have the time and the resources to analyze them and, most importantly, to trade them opportunistically.

The genesis of RiverNorth Core Opportunity Fund is the idea for an open-end fund that opportunistically invests in closed-end funds trading in the secondary market, taking advantage of discounts, premiums and dislocations in that space.

We have combined closed-end funds with ETFs exposure, because discounts and premiums of closed-end funds often ebb and flow for irrational reasons. When discounts narrow, we would typically sell closed-end funds, but we wouldn’t go into cash because that would mean timing the market. Instead, we replace that asset class exposure with ETFs. In the opposite case, when discounts widen, we would buy more closed-end funds and sell ETFs.

We don’t time asset classes, but we time the closed-end funds discounts, which are known and published daily. That’s how we add excess return. For example, we buy at a discount of 10% and, if that discount narrows down to 5%, we receive excess return on top of the underlying assets. That alpha source is unique and specific for closed-end funds; we can’t get it anywhere else in the capital markets.

Q: What is the market size and the nature of closed-end funds?

A: The closed-end fund universe is about $250 billion, spread over 500 funds and predominantly owned by retail investors. About two-thirds of the space represents fixed income funds and one-third is in equity and hybrid type of funds. Probably half of the fixed income funds are taxable, while the other half represents municipal bond closed-end funds.

The taxable fixed income funds include high yield, investment grade, mortgage-backed, bank loans, multi-sector bond funds, preferred funds, etc. On the equity side, the universe includes everything, from US equity to international or global equity, emerging markets, MLPs and sector-specific funds. All closed-end funds trade on the New York Stock Exchange. Actually, one in six securities traded on the NYSE is a closed-end fund.

Such a broad universe allows us to create a truly diversified asset mix, which is similar to a diversified portfolio of ETFs across various asset classes. The main difference is that the market price is dictated by supply and demand because of the fixed number of shares issued at the IPO. In some instances, the market price can drastically deviate from the net asset value or the underlying value of the closed-end funds.

That’s where RiverNorth exploits that inefficiency. Again, retail investors often buy and sell due to fear and greed. On the greed side, it is done for yield purposes or for chasing hot asset classes. Therefore, discounts tend to narrow down and funds may even trade at premiums. On the other hand, asset classes can trade at big discounts when they tend to be out of favor or exhibit volatility. RiverNorth is often buying when retail is selling and selling when retail is buying.

Q: What core beliefs drive your investment philosophy?

A: At the core of our philosophy, we believe that the markets are relatively efficient, but closed-end funds have an inefficient wrapper. That wrapper gives us the ability to opportunistically buy asset classes at discounts and premiums to their net asset value. That’s a solid risk-adjusted alpha, which is significantly different from taking a bet on a company.

We believe in delivering highly diversified asset mix and adding alpha through timing the closed-end fund discounts, not timing the asset classes. We don’t try to predict the markets, including fixed income, equity or the global markets; we don’t try to predict macro trends or interest rates. We aim to construct a diversified portfolio over various asset classes and to maintain a consistent risk profile on a diversified basis.

Our goal is to add the unique, risk-adjusted alpha of trading discounts. If the closed-end fund discount goes from 10% to 8%, that provides an excess return of 2.2%. If it goes from 10% to 12% that’s 2.2% of negative excess return. When the discount is widening, we are comfortable to buy more, because we aim to exploit the value dislocation.

One of the advantages of closed-end funds is that we know their worth every single day. It is published and there is no dispute about it. It is like owning a mutual fund at a discount or a premium depending on supply and demand. In times with a lot of volatility, like in 2008, the summer of 2011, the taper tantrum in 2013, or the fourth quarter of 2018, discounts can widen drastically. These extreme times present attractive opportunities for RiverNorth and we increase our closed-end fund exposure significantly.

Q: What market structure causes these discounts? Could you explain the reasons for their existence?

A: Well-known managers of closed-end and open-end funds raise capital in a closed-end fund wrapper, which then becomes a fixed pool of assets. For instance, last month BlackRock raised $2.3 billion in a healthcare closed-end fund by buying publicly traded healthcare equities. That means that they issued a fixed number of shares. When such a fund goes public, it goes predominantly in the hands of retail investors.

If investors want to get out of that fund, they need to find a buyer in the secondary market, who is willing to pay the price the fund is trading at. The market price in the secondary market is dictated by supply and demand. It deviates from the net asset value, or the value of the underlying assets minus the liabilities, and the fund trades on the NYSE just like a regular stock.

According to our research, about 94% of the $250 billion in closed-end fund assets are in the hands of retail investors. The universe is underfollowed by institutional investors. The funds, when trading at a discount to NAV, often get in a range and continue to trade at a discount. The major difference with regular mutual funds and ETFs is that closed-end funds have fixed number of shares and the market price is dictated by supply and demand.

Q: Do you use screens to narrow down your universe?

A: There are about 500 funds and we can distribute them into various asset classes. Our team knows the space inside out, so our process differs from researching and following companies. There aren’t as many moving parts in the closed-end fund space on a quarterly basis and we can get to know the funds thoroughly relatively quickly.

We use screens, but we also have proprietary execution management systems to trade the funds at discounts. We estimate each closed-end fund’s discount intra-day, throughout the day, and then trade off that discount versus the price. With little help from technology, the system is quite efficient.

Just like regular mutual funds, closed-end funds are required to publish the NAV every single day at the end of the day. So, we know what the fund is worth, but we take a step further. Our algorithms estimate the developments within that NAV throughout the day and compare it to the market price. That system gives us a real-time discount. When we put an order, we put a limit discount order in that limit price.

Our goal is to continue to buy wider discounts and sell narrower discounts on a highly diversified asset mix. We believe that’s a good recipe for excess return on a risk-adjusted basis.

Q: Could you describe your research process?

A: We bucket our trades in three different ways. We look at the current discount relative to its historic trading, relative to its asset class peers and relative to the entire closed-end fund space. We also examine the underlying portfolio to search for catalysts that would cause the discount to narrow down, because we don’t want to own a fund for years at a discount.

The second bucket is trading around corporate actions. These are event-driven catalysts, which are typically underfollowed, but provide opportunities to take advantage of discount movement. For example, if a fund decides to buy back 20% of its shares at NAV, while trading at a discount of 15%, investors will get 20% of their money back at NAV just by participating. They will make more than 3% excess return by getting their money back at NAV.

That’s literally free money, but tender offers typically come in low participation rates. That proves that the space is inefficient. Retail investors may overlook the opportunity provided by a tender offer, because they are not following their closed-end fund portfolio day in and day out. In that case, we can take the excess shares and get more of our shares tendered.

Other examples of corporate action include funds that issue more stock at a discount to NAV, conversions to open-end funds, mergers, dividend cuts or increases. We track and follow all these corporate actions to trade around them, while the retail investors typically overlook them.

The third bucket represents shareholder activism. We are not activists ourselves, but we follow the institutional owners as a potential catalyst for narrowing discounts. Without being activists, we can rotate our capital to a better opportunity if it presents itself. From our perspective, being able to generate excess return from a catalyst that narrows discounts makes a lot of sense.

At RiverNorth, we like uncertainty and volatility, because they make the discounts move around and create more trading opportunities. For example, we may buy a closed-end fund with high correlation to the S&P at 10% discount. When that discount gets narrower, we sell the fund at a discount of 5% for example. Then we rotate that capital to another fund and the discount widens back to 10%. Meanwhile, when it narrowed, we have generated 5.5% more return than the S&P 500, because we owned the S&P 500 in a closed-end fund wrapper. When the discount goes back from 5% to 10%, we would sell the ETF and buy the closed-end fund again.

The more times that happens in a year, the more excess return we add on top of a diversified asset base.

Q: Would you give an example that illustrates your research process?

A: We need to look at the attractiveness of the discount in relative terms. For example, a fund that we are researching is trading at a 15% discount to its NAV. During the last three years, the average discount has been 16%, so the discount has slightly narrowed. At the same time, approximately 35% of the fund is invested in Berkshire Hathaway stock. In that example, if the fund starts trading at a discount of 20%, it would be interesting. We focus on the relative range of the discount and we trade around the mean reverting characteristics of that fund and the discount volatility.

However, we may still want to own a fund, even if it is trading at a narrower discount than the long-term average. The reason would be the asset class momentum or expecting the demand to increase from a behavioral standpoint. We do have appreciation for behavioral finance. If we consider certain asset classes attractive and other investors follow, there could be momentum and we want to ride that wave. Our approach is not purely quantitative; we have some qualitative screens and appreciation for the behavioral side.

Q: Why do investors subscribe to the IPOs of closed-end funds when these funds are likely to trade at a discount in the near future?

A: RiverNorth is also an issuer of closed-end funds and we have had an impact on the industry. In addition to the Core Opportunity Fund, we manage five listed closed-end funds. Just several years ago, if somebody raised $1 billion for a strategy, 5% of the money would go for broker fees and other fees. That means that $50 million would be used for fees and you would have a security worth $950 million. When that security goes public, its market price would be $20, but the underlying value would be about $19.05. That means that the security would trade at a premium of about 5% to its net asset value.

In 2018, RiverNorth decided to subsidize these fees for our Opportunistic Municipal Income Fund. Effectively, it was bought out at net asset value. Now that approach has been adopted as the closed-end fund IPO model.

Another difference is the lifetime of the funds. Historically, closed-end funds are perpetual securities; they would go on forever with no finite life. The new closed-end funds typically have a 12-year term. In the worst-case scenario, investors can get their money back at NAV in 12 years. So, a fund would not be trading at a discount of 15% if the investors knew that they would get the NAV back and that the fees at the IPO are paid by the sponsor, not the shareholders.

Q: Would you describe the portfolio construction process?

A: Diversification plays a key role in the portfolio construction. We believe that we manage one of the most diversified funds by owning 100 closed-end funds and ETFs. Each closed-end fund and ETF typically has hundreds of securities that are spread over various asset classes. These asset classes are often negatively correlated.

We use a blend of benchmarks because we manage both equity and fixed income. We use the S&P 500 index and the Bloomberg Barclays Aggregate Index. Ultimately, we are in the category of moderate allocation funds, but we focus more on having a good Sharpe Ratio and risk-adjusted return.

Typically, our closed-end fund exposure is 50% to 70% of the assets and the rest is invested in ETFs and cash. When the discounts widen, the exposure increases to above 70% or 80%. For example, in 2008 we invested more than 90% of the assets in closed-end funds, because the discounts were unprecedented.

We own ETFs to maintain the risk profile of the asset mix. Historically, the underlying beta of the portfolio has been around 0.5 to 0.6 to the S&P 500. We normally maintain a balanced risk profile to the equity markets and then add the excess return from the closed-end fund discounts.

Q: How do you define and manage risk?

A: We define risk as the permanent loss of capital. When we invest, the key question is whether we can get the investment back. For example, in the fixed income market, buying a 30-year AAA bond comes with duration risk, but the risk for permanent impairment is quite low. Our goal is to literally eliminate permanent loss of capital.

The fund doesn’t have individual company or sector risks; it has asset class risk. However, we’ve diversified that risk over equities, fixed income, alternatives and many sub-asset classes. Diversification is at the core of the portfolio and is crucial for avoiding exposure to any individual name. Each individual position represents a very small percentage of the portfolio.

We often stay away from closed-end funds that exhibit too much NAV volatility and we tend to invest in asset classes that we can feel comfortable with. With our two benchmarks being the Bloomberg Barclays Aggregate and the S&P 500, certain risks that can lead to permanent loss are just out of bounds.

There is correlation risk when the discounts are correlated with certain risk assets. That’s where the cash in the portfolio comes into play. We can increase the exposure in ETFs and buy more of that diversified mix in times of volatility. It’s a risk-adjusted approach of generating alpha. At the end of the day, we can outperform many firms because we buy the funds that they manage at a discount to the historic trading. When that discount narrows, we receive excess return.

Annual Return 2019 2018 2017 2016 2015 2014 2013 2012 2011
RNCOX 22.13 -8.27 17.76 12.17 -5.89 6.28 15.39 14.57 -2.18