Focus On: Virtus Herzfeld Fund
Q&A with Eric M. Herzfeld,President, Thomas J. Herzfeld Advisors, Inc.
Finding solid additions to a diversified portfolio remains a struggle for many investors. This contribution to our “Focus” series discusses the opportunity found in the market for closed-end funds. Though less familiar than other securities to many investors, they offer the potential for attractive long-term returns with a volatility and correlation profile that may complement a basket of more-traditional holdings.
Tell us about the investment opportunity that closed-end funds (CEFs) offer.
The closed-end fund market is both large and obscure. CEFs are publicly listed equities that represent roughly one out of 10 stocks on the New York Stock Exchange (NYSE). There are approximately 523 CEFs, and their total market capitalization is $237 billion (as of 3/31/17).
Like open-end mutual funds, CEFs hold an underlying basket of securities which may include stocks, bonds, real estate, energy interests, or other assets. But unlike open-end funds, the value of the CEF’s underlying assets, known as its net asset value (NAV), differs from the price at which the fund trades.
The specialized nature of CEFs, combined with confusion about how they work, makes this an underfollowed asset class. We believe that presents opportunities.
Because the price of a CEF is often less than its NAV, we can systematically extract value by buying a fund—and all of its underlying assets—at a discount. For example, in the case of a fund that is trading at a 10% discount to its NAV, we can purchase $1 worth of assets for 90 cents.
How did you get involved in this niche market?
Closed-end fund investing is our family business. My father, and firm founder, Thomas J. Herzfeld has been a recognized CEF expert for more than four decades. He originated the Barron’s Herzfeld Closed-End Average, the premier benchmark for this asset class, and is the author of several books on CEF investing.
My colleagues and I are continuing his work by seeking to identify inefficiencies in the CEF market. Today, our best ideas are captured in the Virtus Herzfeld Fund, which we launched in September of 2012.
What advantages do you bring to CEF investing?
We strongly believe we have an edge in this market based on both our pedigree and our process. We like the fact that the CEF market is riddled with inefficiencies. While many stocks—think Apple, IBM, or Wal-Mart—are followed by thousands of analysts, the securities in our world are not widely covered.
In addition, this market is dominated by individual investors. They often chase wide discounts or big yields without fully understanding the risks of doing so. We see a lot of emotional buying and selling, and this creates opportunity. Our rigorous process allows us to avoid emotional trading. We have a deep understanding of the CEF market, and we know the boards and the investment managers of these issues.
We also strive to add value in light of the fact that CEFs are actively managed funds. We look for good managers who are skilled at owning attractively priced assets, just like one would do with an open-end fund. This gives us two potential sources of profit: the price-to-NAV discount, and NAVs that themselves are undervalued. We like be able to earn returns in different ways.
What is the goal of the Virtus Herzfeld Fund?
The Virtus Herzfeld Fund (A: VHFAX; C: VHFCX; I: VHFIX) strives to deliver attractive total returns by investing in CEFs that offer exposure across all major global asset classes. Over full market cycles, we seek to generate a 5% to 6% return over inflation. We expect this to translate into a high single-digit annualized return over time.
While the conventional wisdom views CEFs as high-yield products, the Virtus Herzfeld Fund is not a yield play. Although our income rate has historically tended to be twice that of the S&P 500® Index, it is less than that of the average closed-end fund. We are not willing to take on the risk that stretching for yield would entail, particularly since income in the CEF market comes from a mix of yields, dividends, and return of capital.
How would you describe your investment process?
Our process is informed by our adaptive mindset. To build the portfolio, we combine fundamental research with a trading instinct that is based on deep experience.
We start by rigorously analyzing the key metrics that skilled CEF investors are familiar with, including discounts and premiums, distribution yields, trading liquidity, and underlying holdings. But we then go to a deeper level that most don’t. Among those areas we delve into are:
- the volatility and trading patterns of each CEF;
- how shareholder stakes have changed over time;
- leverage profiles;
- distribution policies;
- anti-takeover provisions;
- “lifeboat provisions”;
- corporate governance; and
- taxation issues.
We have found that our systematic approach, which includes a close reading of the complex legal and regulatory filings for each CEF, gives us an information edge over many others in this space. We are willing to do the time-consuming work in order to fully understand this market.
Our process produces a portfolio of 35 to 40 CEFs, which is less than 10% of the investable universe. We actively trade these issues with the news flow, shifting fundamentals, and supply/demand dynamics in mind.
We are opportunistic investors who do not hold a bias toward any asset classes. In some market environments, the Fund will be weighted toward equities, and at other times we’ll hold a larger position in fixed income. We also maintain a meaningful cash position to fund new opportunities that may arise.
How do you determine when to buy and when to sell?
Ultimately, we seek to extract value from the spread between a closed-end fund’s NAV and its trading price. Our research process allows us to identify catalysts for how a fund’s discount will change. Buying based solely on a wide discount is naïve, even dangerous. Instead, we look for a corporate action that a fund is going to take, such as a tender offer or rights offering, that could narrow the discount.
Because we’ve done our homework, we are not afraid to buy a fund that is trading at a wider-than-average discount. We use our information edge to buy when others are selling, which puts us in a position to make money when the discount narrows. This is natural dollar-cost averaging— we’re buying more when the price is lower. When we have confidence in the manager of the underlying fund, we may decide that even a widening of the discount offers a good opportunity to buy valuable assets for less.
When we see a fund trading at a discount that our analysis deems to represent a statistically significant deviation, we typically increase our position. When that deviation wanes, we reduce our position. We look to add alpha on top of what the strong managers we pick are doing based on a fluctuation. For example, the PIMCO Dynamic Credit Fund (NYSE: PCI) is a well-managed fund that traded at a significant discount during 2016. We took advantage of this fluctuation by buying more as the discount grew to as large as -15.1%, and then exited the position early in 2017 as the discount shrunk to about -2%. We took the proceeds from that successful trade and allocated them to a fixed income fund with a similar portfolio that was trading at a much wider discount.
Where does risk management fit into your process?
Managing risk is the first order of business at Herzfeld. When we look at the more than 500 choices we have to build our portfolio, we reject any that we think present uncompensated risks. We rank opportunities to see which offer the best reward potential for the least volatility.
Many retail investors, focusing solely on income, will buy a CEF with a huge yield. But that strategy often ends in tears because the high yield is often a sign of risk rather than opportunity. Our process digs deeply enough to understand what risks each CEF presents.
For example, we managed to avoid the bond market sell-off in the fourth quarter of 2016 based on our analysis of the fixed income market, the CEF market, and most importantly, our understanding of the structure of individual CEFs.
The vast majority of fixed income CEFs utilize leverage. As the cost of leverage moved sharply higher in 2016, we decided to limit our exposure to fixed income CEFs and avoid municipal CEFs altogether. Instead, we allocated to CEFs and business development company (BDC) preferred shares with fixed coupons. These holdings performed well in the fourth quarter of 2016, posting gains while offering attractive yields with little to no interest rate or leverage risk. Municipal CEFs, which we had totally avoided, dropped 9.29% during the fourth quarter. This illustrates that, when it comes to CEFs, it is not always what you buy, but rather what you avoid that matters.
Where does the Virtus Herzfeld Fund fit in an investor’s portfolio?
We’ve positioned the Virtus Herzfeld Fund as a total return fund which is global and opportunistic across all major asset classes, and whose key portfolio function is as an equity diversifier. By equity diversifier, we mean that the Fund takes on meaningful equity risk—don’t forget that closed funds are technically equity securities. But, the Fund is unconstrained and flexible so it can, and does, look quite different from the crowd. Correlations vary over time from high to quite low. Such is the nature of an idiosyncratic opportunity.
What else should investors know about the Fund?
Because the Fund has significant exposure to global equity, bond, real estate, and energy markets, its price can be volatile. Because it is a long-only fund, it tends to struggle during equity or fixed income market declines.
During those episodes, however, closed-end fund discounts tend to widen. And while the price of a fund might decline, the underlying assets may not be down as much. It’s here where our discipline matters. During drawdowns, we historically have added to our positions because we have cash on hand. We believe that the bigger the discount, the bigger the opportunity—in our Fund and in the industry as a whole. Then, as markets recover and discounts narrow, we tend to start trimming back our positions to more neutral levels.
The Focus series is a production of Virtus University. To learn more, visit Virtus.com, follow us on Twitter @Virtus, or call 1-800-243-4361.
Leverage: The use of borrowed capital to increase the potential return of an investment. While leverage magnifies both gains and losses, it comes with greater risk. A leveraged portfolio can suffer greater losses than a non-leveraged portfolio.
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.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
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