From the May 2010 issue of Investment Advisor • Subscribe!

May 1, 2010

The Up Side of Fear and Greed

RiverNorth Core Opportunity takes advantage of inefficiencies in the closed-end fund business in an open-end mutual fund

Retail investors buy and sell securities for various reasons, many of which are based on either fear or greed, and that can creat inefficiencies that make for fantastic investment opportunities for the astute investor. According to Patrick Galley, chief investment officer and co-portfolio manager of Chicago-based boutique investment firm RiverNorth Capital's RiverNorth Core Opportunity Fund (RNCOX), there is no better asset class through which one can capture those opportunities that are the result of fear and greed than closed-end funds.

Owned primarily by retail investors, the world of closed-end funds (there are about 800 of them with $200 billion in assets, Galley says), whose shares trade mostly on the New York Stock Exchange, offer a unique way to generate alpha, because they trade at either a discount or a premium to their net asset value (NAV). "They're one of the few investment vehicles where it's possible to know what they're worth versus their share price, or what an investor is prepared to pay for them," says Galley, a veteran of the closed-end fund space.

Since inception in 2006, RNCOX has capitalized on the discounts at which closed-end funds are trading. In the mutual fund space, the fund is unique as an open-ended, pure-play vehicle investing in closed-end funds that have the potential for discount narrowing, and as a result, RiverNorth is one of the largest closed-end fund investors in the country.

"We believe the discounts at which closed-end funds are trading are very measurable because they tell us what investors are thinking. If we like the discount and if we like the asset class, there's clear alpha for us when the investments come back to the asset class," Galley says.

Of Junk and Equity

In the last quarter of 2008, for example, high-yield-bond closed-end funds made for extremely attractive investments because they were trading at substantial discounts to their NAVs. "The world was falling apart, so everyone was selling high yield, and we love that, because people were selling for irrational reasons and we were buying for fundamental reasons," Galley says.

Similarly, equity closed-end funds were trading at wide discounts to their NAVs in 2009 as investors, fearful of the equity markets, poured their money into fixed-income vehicles. This dynamic also created some opportunities for RNCOX, which had a more long-term, fundamental view on equities as an asset class.

Galley and RNCOX's co-portfolio manager, Steven O'Neill, employ a balanced strategy with a tactical overlay, splitting their $350 million portfolio 60%/40% between equities and fixed income, generally moving away from asset classes that are expensive toward those that are cheap or offer fair value. They do this by investing in closed-end funds that are trading at a discount to generate alpha. As discounts on particular closed-end funds narrow, the duo trim their exposure to those funds and deploy the cash elsewhere, always keeping in mind their broader asset allocation parameters.

Galley and O'Neill also invest in some exchange-traded funds (ETFs) to provide beta.

"It's very important to understand that we're not investing 100% in closed-end funds," Galley says. "We try to be flexible in that we believe a closed-end fund is the best way to generate alpha through the narrowing of discounts, but if the discounts widen, then we will invest in ETFs."

Rather than making huge bets in order to generate additional return, RiverNorth tries to judge what asset classes are expensive and goes towards those that are cheap or fair value, using both closed-end funds and, to a lesser degree, ETFs to implement that strategy, Galley says. The potential for the discounts to narrow in closed-end funds is the core of the team's investment strategy, but absolute discount levels are not the only indicator they follow: "While a fund trading at a 15% discount sounds great, there might be a better opportunity at a more narrow discount," Galley says.

As such, RiverNorth spends a lot of time and effort performing rigorous fundamental analysis--both qualitative and quantitative--of the closed-end funds in which RNCOX is considering investing. The team uses proprietary statistical models to compare various discount levels and also digs deep into the closed-end funds they're interested in, Galley says, so that they can get a strong handle on the discounts at which those funds are trading as well as into the various factors that are driving investor behavior. This kind of analysis enables the investment team to base their decision on whether to invest or not in a particular vehicle on more than its absolute discount.

Of Shareholder Activism

This in-depth study of the closed-end fund universe also unveils investment opportunities that can be had both in times of market chaos and normalcy, throwing up such issues as shareholder activism and the influence it can have on a closed-end fund. Sometimes, particularly when financial markets are less volatile, institutional investors in closed-end funds may be looking to push the board of directors of those funds to take certain actions (the most extreme of which would be liquidating a fund) that would impact the performance of a particular fund and cause it to trade at a discount or a premium, Galley says. Institutional investors typically make up about 15% of a closed-end fund's investor base, and while they don't always have a pull, there are certain situations in which they can exert their influence.

"Our value proposition is that we can analyze funds for these kinds of occurrences as well, because we are doing research on a daily basis," Galley says.

Overall, "what's unique about this strategy is that it is very flexible," says Brian Schmucker, CEO of RiverNorth and head of operations at the firm. "It's not just about mean reversion trade opportunities, like the kind we saw in 2008 and 2009, or about corporate action or shareholder action trades: It's all about how much exposure we have to closed-end funds and where we're focusing our efforts in terms of understanding those funds."

RNCOX's investor base--almost exclusively financial advisors who, like Galley, O'Neill, and Schmucker, understand closed-end funds and their inefficiencies--are aware that the management team is not timing its investment strategy on discount levels alone, Schmucker says. RiverNorth has built both expertise and a reputation in the closed-end space, so advisors who don't have the time, resources, and knowledge to trade closed-end funds themselves can benefit greatly from the alpha opportunities generated by investing in the space, he says.

"Most advisors who invest directly in closed-end funds know it's difficult to keep tabs on everything," he says. "We know closed-end funds, we like them, and we are specialists, and this is why they come to us."

Fear and Capacity Constraints

But Schmucker also admits that it is not always easy to analyze closed-end funds and the extreme volatility of 2008 and 2009 made it very hard to figure out where exactly the opportunities lay. Closed-end funds got hammered as discounts widened to unprecedented levels, he says, and making sense of the madness took a lot of hard work, rigorous analysis, and dedication. Ultimately, though, most of the volatility was caused by investor fear, and having a long-term view as well as a strong sense of the fundamental, long-term wherewithal of various asset classes helped RiverNorth make the most of the opportunities thrown up by the crisis.

Being a specialist investor in the closed-end space also has its drawbacks in the sense that the universe of closed-end funds is not infinite, Galley says.

"There are definitely capacity constraints within our strategy because there are only a select number of funds out there and it does take a lot of time, money and willpower to do this," he says. "We will probably have to close this fund at $450 million or $500 million because in order to generate this alpha, we can't manage billions of dollars."

At present, the greatest opportunities in the closed-end space are to be had in equity closed-end funds, Galley says, since inflows into fixed-income funds are still strong.

"You can get a U.S. closed-end equity fund at a discount of 15%-plus to NAV, and then on top of that, if you have funds going through corporate actions like tender offers, where shares are being bought back at the NAV, then that's a great deal," he says.

As a firm, RiverNorth manages a total of $500 million in assets, and in addition to the RNCOX mutual fund, runs a couple of hedge funds that arbitrage closed-end funds, and some separately managed accounts. RiverNorth also runs a municipal bond strategy that invests in municipal bond closed-end funds. Currently, 64% of RNCOX is invested in closed-end funds. The fund has a 22% exposure to ETFs and 14% of its holdings are in cash.

Both Schmucker, who founded RiverNorth in 2001, and Galley have substantial amounts of their own money invested in RNCOX, and between them, they own a majority of the firm. Galley joined RiverNorth in 2004 after a tenure at Bank of America, where he got to know the closed-end fund space intimately. The analysts that support him and co-portfolio manager Steven O'Neill are all also experts in closed-end funds, and the firm as a whole holds strong by the idea that a unique alpha offering can probably add greater value to an investment portfolio than most other holdings.


Savita Iyer-Ahrestani is a freelance business journalist currently based in New Jersey. She can be reached at siyerwriter@yahoo.com.
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