Fixed Income Closed-End Fund Strategies

Andy Hunt, CFA: Hello. This video is for those of you who seek market like fixed income exposure with the potential for consistent and diversifying excess returns or without adding leverage or illiquidity. I'm Andy Hunt. I'm a senior investment strategist here at Allspring, and I'm joined by Scott Eldridge to share insights on a strategy designed to do exactly that. Scott is a senior portfolio manager in our closed-end fund team. He and his team have a long history of delivering and managing portfolios in the equity and fixed income space that take advantage of inefficiencies in the closed-end fund market. Today, we'll focus on their fixed income strategies. So Scott, first off, tell us about the basics of closed-end funds.

Scott Eldridge, CFA: Great. Thanks, Andy. Happy to. So closed-end funds are similar to traditional types of funds like mutual funds in that they invest pools of shareholder capital. Closed-end funds have been around since at least the 1860s, and today there are over 500 large closed-end funds that we look at across both the US and the UK with over around 400 billion in total assets. Now, unlike mutual funds, which grow or shrink as money flows in or out, closed-end funds have a fixed number of shares outstanding. The shares, they trade on secondary exchanges. So whereas traditional mutual funds, they're bought and sold at their net asset value from the fund provider, that net asset value, it's the market value of the stocks or bonds in the portfolio, closed-end funds trade at a price where buyer and seller or demand and supply meet in the secondary market.
So what this means is that the price of a closed-end fund can and does disconnect from its net asset value. These funds, these closed-end funds trade at premiums or discounts to the market value of their holdings. And this relationship is not static, it's actually dynamic. So it's the expansion and contraction of these discounts, that's where the real added return opportunity comes into play.

Andy Hunt, CFA: So as you say, the closed-end fund discount is the unique part of this and the key part of your investment philosophy and process. But why does the discount exist and how do you use it for your advantage?

Scott Eldridge, CFA: You're absolutely right. The discount is a key in unlocking our unique source of excess returns. Generally speaking, we want to buy funds when discounts are trading wide or large relative to their historical average. And we'll look to sell that fund when a discount narrows, all in the context of what's going on with other funds in the market. Now you asked about why do these inefficiencies even exist? The biggest reason is that this is a market that is dominated by roughly 75% retail participation. There are very few of us institutional players in the space and retail investors often lack the discipline, the knowledge, the skill and the tools to consistently make unbiased decisions. And they're not always consistently pursuing excess returns. They've got their own priorities. Life happens. We've all been there. You pay taxes, you put kids through college, you get an annual bonus. Sometimes retail investors, they need to either liquidate positions or put money to work regardless of the attractiveness of the premium or discount.
They're essentially forced buyers or forced sellers. Whereas our team, we're bringing institutional tools, institutional approaches to seize on these market inefficiencies and seek to generate excess return for our clients. And we've been doing this for decades. Our strategies date back to the 1980s.

Andy Hunt, CFA: So what do your strategies look like?

Scott Eldridge, CFA: So our clients are invested in fund to fund portfolios. Each portfolio is designed to have beta characteristics similar to its benchmark. We seek to hold those closed-end funds that are trading at attractive discounts, but we also want well-run funds. We don't want funds that will be a drain on performance because of subpar security selection. Each client account holds anywhere from 30 to 100 vetted closed-end funds that we believe have the potential to deliver excess returns. We actively manage the portfolio. Annual turnover runs 25 to 40%. And a big part of portfolio construction and completion, sometimes we have to fill in gaps for beta exposure or for risk management, we use exchange traded funds because of the cost, tax, and operational advantages. Now, while we strive to be fully invested in the market from a beta perspective at all times, that may take different flavors.
In some markets, that means portfolios are close to fully invested in closed-end funds. But sometimes when discounts get narrow, low across the board, the ETF holding might actually increase as a percentage of the total portfolio, serving as essentially a beta generating form of dry powder for us while we wait for opportunities to pivot back into closed-end funds. Now, importantly, because the excess returns come predominantly from how we manage around those closed-end fund discounts, our strategies can provide a unique source of alpha relative to traditional active strategies.

Andy Hunt, CFA: And as those of us have been around for a while, know that's a rare and valuable thing. So how do clients use your strategies?

Scott Eldridge, CFA: Yep. It's a good question. So keep in mind, our clients are generally tax-exempt institutions. So think private, public pension plans, universities, endowments, some insurers, and some hospital systems. We see these clients use our strategies in a few different ways. Now, first, because of the unique source of alpha that we've been talking about, these strategies can often offer a complimentary and a typical source of excess return. So when viewed in that light, the CEF allocation can be seen as an attractive low correlation alpha contributor when paired up with another traditional active manager. But that's not always the case because the strategies are designed to deliver beta of close to one over time, we actually see some clients using them as their core exposure to a market category. So for example, we've got nonprofit investment offices that add our fixed income bond CEF strategy as their core, or they might use it as their core plus allocation.
We've also seen defined benefit pension plans consider our fixed income credit strategy as a component of their liability, the duration investment strategies. So in addition to the fixed income strategies, we also manage global against global and domestic equity benchmarks with track records that date back as far as 1989. We also finally like to point out that every one of our clients that's invested in a fixed income strategy has also held one or more of our equity strategies. So it's very common to see multiple benchmark exposure for our closed-end fund strategy clients.

Andy Hunt, CFA: Thanks, Scott, for explaining the unique and interesting features of the closed-end fund investing world and the potential benefits for our clients.

Scott Eldridge, CFA: Thanks, Andy. Great to be with you. As always, our team is readily available to discuss these strategies with clients and how we might be able to add value.

Andy Hunt, CFA: So thank you for listening, and please reach out to your Allspring contact for further information.