August 2, 2001

Delivering Yield

YieldQuest makes closed-end bond funds pay off

Everybody needs an angle for their business, and perhaps no one knows this better than Jay Chitnis, managing director of the yield-driven investment advisory firm, YieldQuest.

Chitnis and his group of six colleagues will give advisors expert advice on any yield-driven instrument in which they are interested--closed-end funds, municipal bonds, mortgage backed securities, or just corporate bonds. Yet along with this advice and executing trades for clients (wholly investment advisors and financial planners), the firm has come up with a unique approach to bond investing.

In 1995 Chitnis, then a broker with Gruntal & Co., discovered something peculiar about the net asset value of closed-end bond funds and the actual trading prices of their shares.

"It just didn't seem to fit that a closed-end fund focusing on bonds would be trading at one price today and then at a much higher price only a short time later," Chitnis says. "It's not supposed to work that way."

Six years later Chitnis has made this discrepancy the primary component of YieldQuest's services. In addition to providing advice on yield-driven instruments, clients will frequently get a call from YieldQuest alerting them to opportunities when the net asset value of a closed-end fund has swung drastically out of proportion with its share price. Assuming the advisor agrees to purchase some shares of the closed-end fund through YieldQuest, the firm will then monitor the position and send another call to the advisor when the share price has risen more in accordance with the fund's net asset value.

Since the inception of the Atlanta-based department of First Union Securities in 1998, Chitnis says that it has done about 300 basis points better in annual return than the well-known bond indexes for significant clients. Because the same strategy also applies to closed-end funds dealing in equities, he claims his firm has used the strategy to beat the S&P 500 by a similar amount.

How Do They Do It?

There are several reasons why the share price of closed end funds--both bond and equity funds--would fall so disproportionately (often up to 20%) out of line with the fund's net asset value.

Since the price of shares in a closed-end fund is determined by market demand, the explanation can be as simple as there simply not being enough buyers in the marketplace to handle the sellers. "These funds can trade at times with no regard to the net asset value," says Chitnis. "When someone buys or sells shares in a closed-end fund, there is no one telling them they can't make the trade because it's not in accordance with the fund's net asset value."

Other times, there may be large tax liabilities associated with a closed-end fund. Some of these funds have been in existence for a number of years and are holding assets that may have substantially appreciated. Thus investors might be unwilling in the short term to pay a price for shares that would be in accordance with the fund's net asset value.

External factors like a lack of awareness among the investing public about the fund--closed-end funds rarely advertise--may contribute to a lack of buyers. Possibly even a company event, like a crucial shareholder meeting, might be cause for a variance between share price and NAV.

In all of these events, YieldQuest will look for a situation akin to the one that developed with the Liberty All Star Growth Fund between 1996 and 1998. In 1996, the fund traded in the range of a 15% to 18% discount to its net asset value. Presumably, YieldQuest clients would receive a call at this time alerting them to the situation. Then, in early 1998, the share price and the NAV came together at about $14 each.

Yet Chitnis warns that it isn't as easy as looking at graph lines of the NAV and the share price. "There are many times when they are not in accordance and the share price will only decline further from the NAV," he says. "This is not a free lunch. There is a lot involved in this process."

Chitnis should know, having spent the last six years plying the strategy. Once realizing the existence of such discrepancies, he began advising his clients while at Gruntal. He then moved to start a group at Oppenheimer based almost entirely on advising clients of these opportunities with closed-end funds. That group didn't have a specific name, but that changed when he moved his staff to First Union three years ago and began calling his group YieldQuest.

The firm acts much like a full-service broker, charging a commission for the advice and execution of the trade (First Union Securities, based in Richmond, Virginia, is the clearing house.) Chitnis says the fee is 95 basis points on the total investment for those investing less than $5 million per year, 85 basis points between $5 and $10 million, and 75 basis points over $10 million.

He adds that the asset being purchased will not be custodied with YieldQuest or First Union, but rather with whatever firm is providing custody services for the client's overall account. "If the client had their assets custodied with Schwab, then we will send the security over to Schwab after the trade is completed. The advisor must alert Schwab that a trade is happening in a subaccount and they will then accept it because they have that written authorization from the advisor."

Currently, all of the firm's clients are investment advisors, about 120. Of that number, Chitnis says that 50 or so trade very actively with the firm.

Yet despite this unique strategy, Chitnis is quick to emphasize that about 60% of YieldQuest's business comes from this strategy. The remainder comes from providing general advice and execution on yield-driven instruments. "If you call us up and ask for a good muni we'll tell you," he says.

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