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Value Added

A Wise Entry to Closed-End Funds

It's not easy to navigate closed-end funds. Best to let RiverNorth's Oaktree High Income steer the ship.

You often hear closed-end funds touted as a way to buy a dollar's worth of assets for 85 cents. This they sometimes are. But CEFs are much more complicated than the slogan suggests. Unless you're an especially savvy — and long-term — investor, you probably should avoid them. What's more, most income-oriented CEFs — which represent the bulk of the CEF universe — are overpriced just now. But read on, and I'll also tell you about a choice new income fund.

Most CEFs are thinly traded, so they're largely the province of individual investors. But some hedge funds and a few mutual funds also troll these waters. I just had a long conversation with Patrick Galley, chief investment officer of RiverNorth, which runs several funds that specialize in CEFs. Take it from me; you don't want to be on the other side of a CEF trade with Galley.

First, let's review the basics. A CEF is a hybrid between an ordinary mutual fund and a stock. Like a fund, it usually owns dozens, if not hundreds, of stocks, bonds or both. After the market close each day, the CEF's sponsor determines its net asset value (NAV) per share based on the prices of the fund's underlying holdings.

Like an ordinary stock, a CEF begins life with an initial public offering. After the IPO, the CEF's price can — and usually does — vary widely from its net asset value. Supply and demand set CEF prices. But there's a crucial difference between CEFs and stocks: Because CEFs own primarily publicly traded stocks and bonds, you can always compute their net asset values. By contrast, figuring the true value of a stock is a never-ending debate.


Let's consider a CEF, Pimco High Income (symbol PHK). Managed by bond ace Bill Gross, the fund's yield, based on a share price of $12.83 and its current distribution rate of 12 cents per month, is 11.4%. Over the past ten years, the fund has delivered a total return (dividends plus share price appreciation) of 12.6% annualized. The fund has returned 27.2% so far this year (all returns, yields and prices are as of May 6).

But here's where things get tricky. The Pimco fund's NAV has risen just 11.0% so far this year — 16.2 percentage points less than the share price! Partly as a result, the fund's shares trade at a whopping 43.9% premium to their net asset value. What's more, the fund is 21.2% leveraged, meaning that for every dollar of shareholder assets, Gross has borrowed 21 cents to invest in additional high-yielding "junk" bonds, the sector of the bond market it focuses on.

Pimco High Income is an extreme case. But it illustrates the kind of madness that has infected the bond world after a 32-year bull market, during which yields have steadily fallen and prices have steadily climbed. Most bond CEFs are selling at premiums today. Stay away, particularly from those that employ leverage.

Galley studies CEFs based on a smorgasbord of statistics. But his core premise is that CEF prices usually revert to their mean. By that, he means that a fund that has on average sold at, say, a 5% premium to NAV over the past three years and then drops to a 5% discount is probably a buy. So is a fund that tends to trade at a 10% discount, then falls to a 15% discount. "Volatility is our friend," says Galley. "The more volatility, the better."


Galley, co-manager Stephen O'Neill, two analysts and two computer programmers immerse themselves in CEF data analysis. They don't put much weight on short-term performance, although they do examine past returns, especially risk-adjusted returns.

Instead, they focus on catalysts that might make a discount shrink. Examples might be an offer by a CEF to buy back some shares at net asset value, a dividend increase or a change in investment strategy. The actual trading is done by computers, which calculate the net asset value of a fund on a moment-to-moment basis.

When they can't find bargains, Galley and company are content to invest in low-cost, exchange-traded index funds rather than buy overpriced CEFs. (Exchange-traded funds contain mechanisms designed to prevent the formation of significant discounts or premiums.)

A few tips for anyone who wants to buy CEFs. 1) Avoid them at the IPO; brokers and underwriters typically take a 5% cut. 2) Don't use stop-loss orders; CEFs are too volatile for that. 3) Don't sell just because a CEF cuts its dividend. Often an anticipated cut is already reflected in the stock price.


Only two of RiverNorth's five mutual funds are open to new investors. One, RiverNorth/Manning & Napier Dividend Income (RNMNX), doesn't appeal much to me; there are better and cheaper dividend-focused funds. As with most RiverNorth funds, part of the fund is managed by an outside firm.

The other open fund, RiverNorth/Oaktree High Income (RNOTX), launched the last day of 2012, looks like a winner in spite of an annual expense ratio of 1.60% not counting the expense ratios of CEFs the fund owns. RiverNorth manages 25% of the fund, investing mainly in high-yielding CEFs. Oaktree Capital — a highly regarded bond-oriented shop that mainly serves institutions and is best known for investing in high-yield and distressed debt — runs the other 75%, investing directly in high-yielding debt. The fund's Class R shares yield just 1.5%, but Galley expects the yield to rise. The fund requires a minimum investment of $5,000.

Oaktree only manages one other mutual fund, Vanguard Convertible Securities (VCVSX), which has a long and superb record, returning an annualized 9.0% over the past ten years. When it comes to risky junk bonds, I'm happy to hire a firm as good as Oaktree. When it comes to CEFs, RiverNorth is my pick.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.