Outlook for Investing in Closed End Funds

EMS:
Absolutely. So to kick off the conversation, tell us a little about the firm, and how you got to where you are today.

JCS:
Yeah, so Closed-End Fund Advisors is a 33-year-old registered investment advisory firm. Our family bought it in distress back in the mid '90s. My father did a career in 50 years in closed-end funds. It really started in the bear market of the '70s, when he and his best friend bought control a broken IPO in that bear market, his best friend had a third of the stock, our friends and family, I wasn't born yet, had 10%, and that led to a wonderful 27-year career. He had been a journalist before he got into the financial markets, and so he bought out a newsletter after the '87 crash in 1988, called the Scott Letter. And then he wrote a book on close-end funds with a finance professor back in 1990, and bought the firm in '96. And I got out of college at the College of William & Mary in 2001, and he needed some help, and I liked the concept of small business and working with families, so I joined him. Young, enthusiastic a lot less gray hair, and I learned a lot from there.

We basically focus on highly customized separate accounts for individual investors, both taxable accounts as well as qualified, using our data business, which I launched 11 and a half years ago, covering every listed closed-end fund, every interval fund, every listed BDC, non-listed BDC, the entire closed-ended management universe, so everything that's not a regular ETF for open-end fund. And we do that as two business lines to offer data and information to our peers, our partners, service providers, boards, really anyone with a need for highly granular and high quality data.

EMS:
Great. John, so given your focus on the closed-end funds industry, love to hear a high level outlook for this space.

JCS:
So right now, we're at an interesting time, we've been doing a quarterly research call, which is publicly available on cefadvisors.com, about 44 consecutive quarters. We're finding that the discount or the listed price of a closed-end management company, whether it's a muni bond fund, or a business developed company, are historically very wide. Now, obviously there's been some challenges with concepts like the cost of leverage, and grappling with economic concerns, so credit risk in the market, as well as duration concerns. We've definitely seen some headlines recently where duration concerns were causing a lot of trouble for investors in what's going on. So what we really try to do is build an asset allocation model. We don't have any pure equity, or any pure credit portfolios for the most part, and we look to maximize what makes sense conceptually for the investor, we then look into the guts of the closed-end funds to find the factors, whether it's a leverage piece, or exposure piece or a duration calculation, and to bring through what the client is asking us to do.

And then our software in our data business wraps up, not only a tight way to show them visually how to get what they're looking for out of the portfolio. And with these listed funds, it's really hard not to ignore discount tailwinds, because the future's always unknown, and nobody actually knows the future, but discounts tend to revert to mean. And so right now, with closed-end funds being relatively wide, there's a lot of opportunity to narrow what's going... What's likely narrow in the future, and give investors increased performance over a less wide discount, or other fund structures.

EMS:
John, given the environment and everything going on, what are some of the greatest opportunities you see in your space, and why?

JCS:
That's such a large question, I wish we had an hour, but your audience probably appreciates we don't have an hour to go over this. I'll take a couple of slices, I mean, the growth of interval funds, which are genuinely illiquid credit and equity, and now there's so many that are available on RA platforms, and wirehouse platforms, where you can get 60, 70, 80% illiquid credit, illiquid equity, so true private exposure that's not really allowed by the SEC's regulations for open-end funds and ETFs, and really get that access, is a beautiful opportunity. So we have clients that we overweight that to drop their volatility, give them access to, really, parts of the market they can't have.

There are tender offer funds for credit investors and private BDCs, where it feels and looks kind of like a hedge fund, but the fees are lower. Like Churchill, part of Nuveen, has a non-listed BDC with a 75 basis points fee structure. And I'm not an expert on hedge funds, you might be, but that's not a regular investment for private credit exposure. On the other side, the 130-year-old listed closed fund market, the largest bucket of muni bond funds. And they've been grappling with duration risk, and dividend cuts, 100 dividend cuts in the last year, really shaking the shareholder base. And as you might know, these investors are mostly retail investors in the United States that own closed-end funds and listed BDCs, and they've really been rattled.

So the discounts are regularly 10 to 15% right now, and the yields have come down, but... Well, think of it, leverage costs are probably nearing the top, I don't know the future of the bond market, but we'd think that they'll be moving from more fixed rate leverage, to variable, and then we expect to have some sort of event which makes people like bonds more than common stock equities, that traditionally will lead to two great factors, NAV performance upside, and discount narrowing.

Two years ago, muni bond funds were yielding a five and a half, and they were trading above net asset value, and people thought they were the easiest best things ever, "Let's all buy muni bonds for everyone." Now, after these dividend cuts, large discounts, the yields are down to four and a half. But the last time we had this pullback of this size, the future was very bright for the structure. We go the other side of the market, the venture loan market with listed BDCs, they're down 25% premium to discount, in the last two years roughly as well. Their dividend coverage two years ago when they performed 200% from the COVID bottom was only 2% over policy for index, now it's 20% over policy, and the dividends are up 10 to 15% across the board.

Again, variable loans matched with fixed leverage, a beautiful math story, and yet the market's still concerned about them. And at the banking crisis, BDCs really proved their stable capital structure, whether they're listed or non-listed, are a great way to have capital go into the markets, and not worry about a run on the banks. 'Cause these are not banks, these are funds with 50% leverage, not two, three, 4%. So those are the most amazing places that we love using for our clients in the right tax, and risk appropriate way.

EMS:
And John, on the other hand, what are some of the greatest challenges you faced in this space, and how do you overcome them?

JCS:
So I started a non-profit, the Active Investment Company Alliance, almost four years ago, to really bring together users of closed-end funds like myself and my peers, fund sponsors, service providers like your firm could be involved, to bring community for contact. And we tackle concepts, really trying to educate that market price volatility needs to be a conversation for a financial advisor, or in the markets that it's not necessarily a risk factor, it should be, no, you should not be buying enlisted securities and not realize that the discount can widen 10 or 15% in a chaotic market. We want to make sure people learn that, and that as long as there aren't four sellers of these funds, they're beautiful investments, because that stable capital base is very resilient in a tough market.

On the other side, interval funds, which are a beautiful structure with a ton of growth, they've been hurting investors, because they don't realize they can't sell them the next day. So we've been working with great firms like Morgan Stanley and other platforms to increase the requirements for advisors to document the education to clients. They understand the why of this fund, and it's a better, more liquid hedge fund than a horribly illiquid ETF. And I feel if you can do that, you can make sure people are using the right wrapper for the right part of the portfolio. You can take these negative things and turn the positives.

And the last thing is, fees are always an issue. And again, we, at our firm, we don't love high fees, but it's the third or fourth thing we focus on. We care much more about a dividend coverage, quality of manager, tapping the right exposure for our clients. Fees are part of our calculation, but what the biggest differences I think people make mistakes on is, they look at the regular expense ratio, whether it's a muni bond fund or a BDC, we do gross non-leveraged expense ratios, and there, over 2/3 of the top 20 closed fund firms, it's under 1% for active management. So I could keep going, you probably don't want me to 'cause it's not enough to cover, but those are some of the big things we really are trying to educate to avoid the chaos of, and just making sure you're using the right wrapper, the fund sponsor, so bringing the right product to market for the financial advisors, and the clients that they serve.

EMS:
John, to shift gears a little bit in the funds industry, ESG, DEI are top of mind overall, love to hear how your firm is addressing these topics.

JCS:
So if you really think what we are at a basic level, we are manager analyzers, we're data collectors, we're trend followers. My dad's DNA is a journalist, my undergrad is at BS in psychology. Yes, I have a full business school and CFH charter holder as a co-MP at the firm. But we really love the story, and bringing this together, we've definitely... We meet with board members regularly of listed closed-end funds of BDCs, and we love the growth in the diversity we've seen, and we've seen some good lead board members really offer more diversified voice than we've seen. The one area I wish there was a better voice is... So many BDCs and closed-end funds, they tend to hire board members that are good at the underlying sector, so I think pipelines, or growth stocks, or venture debt, and they don't seem to really bring on many board members that are good at the structure. Which goes into defending activism, or pushing back on fair market value marks, or addressing a fair fee level, because they're not really in that environment.

We also know there's a few growing funds on the credit side and equity side that have more of an ESG flavor. We really think ESG is not one thing from our research and our understanding, but it's a layer of additional analysis. We don't use it to say no to anything, but we definitely see that it tends to lead to a better environment, and a better workplace for the employees of these publicly traded companies, which then leads to better investment success. But again, it's a tough story, 'cause we also love the pipelines, which provide a lot of tax advantage and income for our clients, and there's some people who would throw those out every time, and we think they're relatively cheap, and there's some great managers in that sector that we really are happy to own for our clients. So it's a tough call, but we do our best.

EMS:
John, we've covered a lot of ground today, and wanted to see if you have any final thoughts you'd like to share with us.

JCS:
Well, I'm always a bit of a salesman in my heart. We do have our own weekly podcast, again, that's partially how we met after the conference, and we'd love people that want to go deeper into closed-end funds, BDC Interval Funds, check out the Navigator, it's the lead segment on Chuck Jaffe's Friday Money Life Show, and a standalone podcast anywhere you find great podcasts. We transcribe them, and they drop every Friday. We also said we cover the sector deeply in a publicly available slide deck, and we have a advisor survey out right now which may be useful for those industry to follow on aicalliance.org. And we have an upcoming conference in the fall. I hope you can be involved in it, 'cause you're a great member of the ecosystem, and we always love having great partners to spread the word on these niche little investments that are getting traction, and hopefully solving great problems for investors and the advisors they work with.

EMS:
John, I want to thank you so much for sharing your perspective with us.

JCS:
Thank you. I'm so glad to be here. I'm glad to be part of your podcast series.

EMS:
And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this, and a host of other topics. And join us for our next EisnerAmper podcast, when we get down to business.

Transcribed by Rev.com