How To Ride Sidecar With CEF Activists

Activist CEF investors advocate on behalf of CEF shareholders and lobby fund sponsors and boards to close fund discounts.

Fund investors can trade alongside activists in a few ways: by investing in their funds or by following SEC filings.

Of the recent activist filings we like IVH and CXH for their solid coverage and yield figures as well as attractive historic performance and current valuation.

One thing we aim to do at Systematic Income is to source investment ideas from a diverse set of sources. One such source is the pool of CEF activist investors. In this article we take a look at this area of the CEF market and see whether there is anything fund investors can learn from it.

Among the recent filings, we like the Ivy High Income Opportunities high-yield fund (IVH) as well as the MFS Investment Grade Muni Fund (CXH) for their solid yield and coverage figures as well as strong historic performance and current valuation.

What makes the closed-end fund market interesting is that occasionally it feels a bit like the Wild West. A number of so-called activist investors roam the CEF landscape picking fights with fund sponsors and occasionally bending them to their will, or at least getting paid off in the process.

Who are these activist investors? In the CEF space, there is a number of usual suspects like Saba, Karpus and Bulldog. Guggenheim used to be fairly active as well, however, they have been relatively quite more recently. This may be because the hey-day of CEF activist has passed as smaller CEFs with more fungible assets have been taken out already and the remaining funds have more sophisticated and patient sponsors.

The activists' general claim is that the combination of high fund fees and locked-up capital means that many fund sponsors and boards have interests that do not align with those of shareholders. Many CEFs fail to outperform and have risk exposures that can be easily and more cheaply replicated elsewhere. This means that many funds have prices that languish for long periods at wide discounts. However, because the CEF capital is locked up, the only recourse shareholders have is to sell the fund.

The activists' primarily goal is to tighten the fund discount. In order to accomplish this they lobby the fund sponsor and board to carry out a number of possible actions. If the fund is not receptive to these requests, activists often file lawsuits and / or launch proxy contests in order to win board seats.

Primary factors are funds that have relatively liquid assets such as liquid stocks and bonds as well as funds with discounts that are at or close to double digits. Other factors include the proportion of institutional ownership (as they more likely to vote and do so inline with their economic interests) and any details in the prospectus that may forestall a vote to liquidate such as a supermajority requirement.

Historically, the primary mechanisms for tightening the discount have been the following:

An interesting recent case of CEF shareholder activism involves Saba and three Invesco Funds: (VTA), (VVR) and (VLT). Surprising many in the market, Invesco has agreed to a tender offer at 98.5% of NAV for all three funds in the amount ranging between 15 and 20%.

The chart below shows how Saba has been building up its position in one of the funds over the previous few months.

The chart below shows the discounts of the three funds with the date of the announcement marked in as a red line.

The first question to ask is 'do activists make money?'. This one is more difficult to answer than it first appears given the different types of risks that activists take - typically, slow-burning, idiosyncratic and hedged. Saba, possibly the biggest CEF activist, launched (CEFS) an actively-managed ETF two years ago that piggy-backs on the company's expertise and activist efforts. For what it's worth, on an absolute basis, CEFS has outperformed other funds-of-funds since its launch.

Investing in CEFS is one approach that fund investors can take. It is fairly hands-off and delegates all the hard work to the Saba team. The downsides of this approach is the 1.2% annual fee plus uncertain sector exposure that may not fit neatly into an existing allocation framework.

Another way to invest alongside activists is via SEC filings 13D and 13G. The 13D filing must be submitted to the SEC within 10 days by someone who acquires a beneficial ownership of more than 5% of a publicly traded company. The 13G filing is the more passive version of 13D but still useful.

To test whether a strategy of buying funds that show up in activist filings works, we calculate the returns on funds listed in the filings, a day after they appear to various dates in excess of the relevant sector. The different dates are:

We test this for two major activists: Karpus and Saba. The results are not overly promising.

For Karpus, all three returns are negative meaning that the funds that pop up in filings underperform their sectors to all three dates.

Returns for Saba filings are more mixed though still uninspiring.

These results don't mean that the funds themselves underperform. First, the strategies weight all the funds equally, whereas in reality the activists size their positions according to the likelihood of success and secondly, the strategy starts off on the day after the first filing date whereas funds typically scale into a fund opportunistically.

Does this mean that investors should ignore what activist investors do? Not exactly. We think that the positions taken by activists are valuable in two ways. First, they can generate trading ideas and push investors to consider funds they may not have otherwise. And secondly, they may offer low-probability lottery tickets. However, we would caution that, given the evidence above, investors should not bank on this and only buy funds they are happy to hold on independent grounds such as yield, alpha, risk exposure and valuation.

Of the current filings from Saba and Karpus, we like the following funds:

Saba Filings Fund Stats

Karpus Filings Fund Stats

Closed-end fund investors can trade alongside activists in a few different ways. They can take a passive approach and invest in funds like CEFS that do all the heavy lifting. Or they can take a more hands-on approach and take advantage of the high-frequency SEC filing 13D that discloses activist positions. In recent filings, we like the funds IVH and CXH for their strong coverage and yield figures as well as attractive historic performance and current valuation.

I am/we are long IVH.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.