FMD Capital Management

Rethinking Risk Management Tactics for Closed End Funds

Written by Michael Fabian, August 07th, 2014

Corrections in closed-end funds (CEF) begin just like any other asset class, driven by fear and discontent with the impending market landscape.  Yet I’ve come to observe many retail investors become disenchanted with even their most coveted holdings when a max-pain threshold has been reached.  In my opinion there are several reasons why investors struggle with swift ebbs and flows, but primarily I’ve found it stems from a lack of due diligence, proper planning, analysis, and portfolio management technique.  These factors can be offset with the proper perspective, and when understood correctly an investor can compound their future profits during times of heightened volatility.

Reassessing Risk Management

You might as well throw your traditional risk management tool kit out the window; these practices simply don’t work with a portfolio made up of closed end funds. Envision it this way, your goal of establishing an attractive cost basis relative to a fund’s NAV is in direct opposition to setting a hard stop-loss at a pre-determined price as a last-ditch means of capital preservation.  Even if you were to use a trailing stop-loss, an arbitrary percentage from the high is not likely to coincide with a good exit point if the fund only becomes more attractive as its price declines in relation to its NAV.

In contrast, evaluating a funds current price in relation to its historical NAV can act as a much better barometer of relative value than a simple percentage-change from your entry point.  This is especially true given the fact that most CEFs implement large distribution policies, which can manipulate a fund’s price compared to your stop-loss price. Prior trading history coupled with a good understanding of a fund’s fundamental traits make up the most basic due diligence that every investor should be innately familiar with.  These traits should include portfolio earnings, distribution coverage, underlying portfolio dynamics, fees, size, leverage, and management team.

When evaluating the risk of potential drawdown, an investor should start by analyzing a fund’s underlying asset mix, predetermine how volatile the assets can become during times of stress, and then finally factor in other influences such as leverage and the possibility of additional discount widening.  These basic steps will offer you a unique viewpoint on the attractiveness of the fund’s market price alongside the underlying portfolio holdings.  In addition, this exercise should give you a working model to calculate total portfolio drawdown if the worst outcome should ever enter reality.

Hedging Isn’t an Exact Science

When chatting with potential clients considering our Dynamic CEF Income portfolio, I’m often asked if we use hedges to offset portfolio volatility.  The first thought that typically enters my mind is: Hedge with what?  What index would you choose?

The S&P 500? Long term Treasuries? Credit Spreads? The volatility index? Or 3-month Libor? (Which is commonly tied to a fund’s leverage expenses).

The crux of the problem is that all of those indexes can apply downward pressure to CEF prices, and not just the funds concentrated in a related asset class, potentially all CEFs.  There are no hard and fast rules to hedging since there is no direct market price correlation with NAV’s, so the severity of the correction can often times depend squarely on the magnitude of the decline of the index in question.  These price fluctuations can even become further exacerbated if retail investors become overly spooked, like during the financial crisis.

In my opinion the best risk management tool and the one we use most often in our client portfolios is a cash buffer.  I view it as a sleeve that can morph from just a few percent when discounts are attractive, to up to 50% when fund prices become over extended.

Going into the most recent correction during the last few weeks, our cash position was at 20%, not low by any means, but in hindsight not as high as I would have preferred.  However, the largest benefit of cash when investing in CEFs is having room to maneuver, by purchasing funds at lower prices; we are essentially able to secure new income streams at higher yields.

We have been patiently waiting months for a pullback in credit related securities to culminate.  So in the mean time we have created an ample shopping list which includes funds such as the Apollo Tactical Income Fund (AIF), The Avenue Income Credit Strategies Fund (ACP), and finally the Legg Mason BW Global Income Opportunities Fund (BWG).

Although I still think there could be additional downside in CEFs if equities remain weak, beginning to think about how to intermingle new funds into your portfolio is key to insure it emerges from the most recent correction in a better position than when it began.  With most fixed income and equity CEFs now trading below their trailing twelve-month average premium or discounts, the time to sell has passed.  What comes next will surely set your portfolio up to take advantage of any year-end strength.  Like all effective strategies, developing a plan, and then implementing it decisively will always produce the best results.

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