The closed-end fund market begins 2010 on a somewhat muted note, without the customary New Year's bounce.
The closed-end fund market begins 2010 on a somewhat muted note, without the customary New Year's bounce. But attractive discounts still abound in the U.S. equities group.
Due to the lack of typical year-end selling pressure in December, closed-end fund discounts remained steady through the final stretch of 2009. Historically, tax-conscious investors harvest tax losses at year-end to offset gains in their portfolios. In turn, tax-loss selling typically creates a supply imbalance that temporarily pushes discounts wider. But last year, closed-end funds bucked the trend and discounts narrowed in December. Given the powerful rally in the capital markets, we suspect that investors struggled to find losses to harvest.
The most attractive discounts on closed-end funds are found within U.S. equities. Many U.S. equity closed-end funds are trading at discounts wider than 15% to their net asset value. We believe these historically wide discounts reflect investors' psychological apathy towards U.S. common stocks. Despite the significant rally from March 2009's low, the equity markets still haven't gained the full confidence of retail investors. In fact, investors continue to pull money out of open-end equity mutual funds. Equity mutual fund outflows for 2009 were negative $11.9 billion, whereas bond funds attracted record inflows of positive $380.6 billion, according to the Investment Company Institute. Retail investors have turned their backs to U.S. common stocks, and the deep discounts on U.S. equity closed-end funds reflect this negative sentiment. Contrarian investors take note – U.S. equities are on sale for 85 cents on the dollar in the closed-end fund universe.
On the new issuance front, the pipeline for closed-end funds witnessed strengthening in 2009, an indication of positive investor sentiment and willingness to put money to work, specifically in fixed income closed-end funds. Last year saw 13 initial public offerings, raising approximately $2.3 billion in new closed-end fund assets. In contrast, this compares favorably to a lackluster 2008 of two initial public offerings totaling $262 million in new assets.
In January 2010, the RiverNorth Closed-End Fund Index (“RiverNorth CEF Index”) returned -2.09% based on closed-end fund market prices and -1.28% based on net asset values. Asset class returns were mixed in January. The strongest and weakest performing asset classes were bank loans and foreign equity, respectively.
For the full-year 2009, the RiverNorth CEF Index returned 56.9% based on closed-end fund market prices and 43.0% based on net asset values. The average discount on the RiverNorth CEF Index on January 31, 2010 was 3.99% versus 3.24% on December 31, 2009.
The RiverNorth Capital CEF Index tracks 75 taxable closed-end funds and is rebalanced annually. The index is designed to provide a highly correlated representation of the taxable closed-end fund universe. This is accomplished through first capturing the diversity of the asset classes in the closed-end fund universe, by using the net asset weights of each asset class in the taxable universe to determine the weighting of the index constituents. For example, if the aggregate net assets of covered call funds represent 20% of the taxable universe, then 15 of the 75 funds in the RiverNorth CEF Index will be covered call funds (20% of the universe * 75 names). Once the asset class weights have been calculated, the fund quotas are filled with the most liquid names in each asset class on an equal weight basis (i.e. the top 15 most liquid covered call funds).
Patrick W. Galley is the chief investment officer of RiverNorth Capital Management, LLC, an investment management firm based in Chicago, IL. The firm specializes in quantitative and qualitative closed-end fund trading strategies and is the investment adviser to the RiverNorth Funds.
