Allocating Closed End Funds
The power of passive portfolios for Family Offices
|Jan 7, 2019||1|
There is a ton of material on passive investing via index trackers. Large Institutions like Vanguard, Blackrock have done a fabulous job of creating index tracking funds and at-least in US and Europe passive investing by institutions as part of overall asset allocation strategy has gained substantial pace over the last decade. ETFs form an integral part of many family offices passive investing portfolios. Wall Street pours out enough research and noise on stocks and ETFs making it easy to get exposure and access to public information on a regular basis easy except Closed End Funds. However, CEFs when properly selected should be an integral part of a family office passive investing strategy. Many in Wall street ignore them because they are not that liquid or don’t understand them. Very simplistically Closed End Funds (CEFs) are funds where no new units can be issued once listed in the exchange but trade like a stock on the exchange during normal trading hours. The CEFs are also much better than open ended mutual fund which you cannot buy or sell during market hours and are subject to a price determination by the issuer at the end of the day. Most of Wall Street does not care about closed end funds because of lack of institutional liquidity for them to make money out of them and therefore it’s a great place for long term investors with a decent passive portfolio who want to generate alpha out of passive investing to be involved tactically or strategically.
There are more than 500 CEFs having exposure to all asset classes and majority of them are listed in the US exchanges. These funds are actively managed by the Issuer, but you get to passively invest in them. Many of them treat income generation as well as capital appreciation as the goal and several of them trade at discounts to NAV (Net Asset Value) with a very strong distribution yield. The recent market sell off has created an opportunity to own many funds at a discount to NAV. If you are looking for funds which give you a 10-12 % gross yield and trading at discount to NAV and having exposure to sectors that you want, then this is the game to play. Very few retail /institutional understand it or know about it and I have hardly heard of anyone talk about it over the last couple of decades. This provides big long-term opportunities. For instance, a closed end fund (ticker: USA) trades at a 7 % discount to NAV and gives an annualized yield of 11.82% where effectively you own Google, Facebook and several blue-chip technology and financial names which are part of the portfolio at a discount to the fair market value. At a certain level owning USA is like owning the S&P500 tracker but at a discount to NAV given its exposure to US stocks is around 90% of the portfolio. A little bit of work going through the major holdings/income distribution strategy/history one can replicate many ETFs with an alpha opportunity. They are actively managed by the fund manager and you may pay slightly higher fees but buying at discount at NAV you take care of the fee part of the cost structure. Plus, you have a free option on any liquidity event such as buybacks which may happen to close the NAV discount. There are number of funds which based on asset allocation requirements in terms of fixed income, commodity, convertibles, preferred, straight equity or sector focus that can be tailored based on liquidity, leverage, distribution yield, quality of distributions, discount to NAV and many other parameters. In case of an overall drawdown in the broader market the funds distribution yield gives a good partial hedge as well.
While many large institutions tend to avoid CEFs because of their lower liquidity for family offices CEFs lower liquidity should not necessarily be a big negative as the liquidity risk is to a certain extent alleviated by the discount to NAV. The recent stock market correction has thrown up some interesting opportunities in the CEF space across different asset class spectrum and for long term investors it opens an opportunity to capture some alpha while following a passive strategy.
It is a matter of time before more hedge funds get involved seeing the significant alpha opportunities especially when you can own several quality assets at a discount especially given the tougher investing conditions over the last year here is an interesting article that goes into more detail. If family offices want to follow a long-term passive investing model which generates smart alpha CEFs are a product one must incorporate in their passive portfolios.
Finally blockchain focused fund managers may also want to consider creating closed end funds that includes not just coins but also top performing digital currencies and companies that have reasonable exposure to blockchain space that can be listed in a crypto exchange or an exchange like Nasdaq OMX (like the open ended Bitcoin and Ethereum Linked Notes) effectively providing a vehicle for long term investors to explore some asset allocation for both the retail investor and family offices to expand the investor base.
Written by Ramesh Raghavan
Mr. Raghavan is currently the Vice Chairman of one of the leading and oldest Angel Investment Networks of South East Asia (BANSEA). He is an early stage venture investor, advisor and board member in several start-ups in Asia-Pacific. His syndicated investments have ranged across several sectors such as gaming, education, fintech & Internet of Things. He has been involved with the innovation partnerships from Israel to India to ASEAN & Hong-Kong. He is also an advisor on risk management in traditional public market investments and alternative investments to family offices and emerging hedge funds. Ramesh prior to his involvement in the start-up/innovation space held global leadership roles in equity/equity derivatives/risk management for Asia Pacific in sales & trading with Morgan Stanley & Royal Bank of Scotland based out of Hong Kong & Singapore. Prior to his career in Investment banking he had a FMCG career in India with PepsiCo & a commodity trading career with Britannia Industries. Ramesh is an MBA from London Business School, Masters in International Business from Indian Institute of Foreign Trade and a Mechanical Engineer from College of Engineering, Guindy, Chennai and holds a FT Non-Executive Director Diploma - Pearson SRF BTEC Level 7 Advanced Professional Diploma as well.
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