Q: What is the history of the fund and what prompted you to initiate it?
The Robinson Tax Advantaged Income Fund is a relatively new fund, dating back to October 2014.
The first seeds were sown when, several years ago, my current distribution partner for this municipal bond fund approached me to formulate an open-ended fund around our taxable closed-end fund arbitrage strategy. At the time I declined, but in late 2013 the municipal bond market became interesting. Municipal bond valuations had become quite dislocated, and when that happens, the closed-end funds that invest in those bonds generally become even more dislocated.
I’ve been a bond trader for 20 years, and when I looked more carefully into closed-end funds, I discovered it was mostly unsophisticated retail money being invested. Considerable academic research exists explaining why discounts exist in closed-end funds, but nothing on precisely how to unlock those discounts. Our goal was to find ways to unlock those discounts.
Discounts exist for various reasons, including bad management, high expense ratios, poor and expensive use of leverage, or because a fund contains difficult-to-value securities or has unrealized tax gains. Nearly all of these factors are quantifiable, so we began by modeling the 400 taxable closed-end funds. We’ve now been tracking them in real time for the past seven years. Several years ago we added the roughly 200 tax-exempt closed-end funds to our valuation process.
One of the reasons people shy away from municipal bond closed-end funds is that they tend to be longer-maturity funds and they use leverage, meaning they borrow when interest rates drop to buy longer-term securities that pay higher rates. A meaningful rise in long-term interest rates will quickly erode any benefits from buying such a fund at an 8% or 9% discount. However, I felt we could address that risk by hedging out the duration risk using short positions in U.S. Treasury futures. That is something we can don in the mutual fund that most individual investors and/or their advisors probably can’t do on an account-by-account basis.
When we started the fund in 2014, it was initially populated by RIAs (Registered Investment Advisors) and some institutional and high-net-worth investors, but recently we’ve also been added to several major wirehouse platforms.
Q: What is your investment philosophy?
Essentially, I want a fund that is broadly diversified across states, across municipal sectors, one that is fundamentally an index fund. Having an index fund at an 8% discount would be ideal.
The challenge in attracting investors with this profile is that what we offer sounds too good to be true. We generate a 4.75%-5% net tax-exempt yield that we distribute on a monthly basis to our investors, roughly 40 basis points a month. We have an average credit rating of about A, and an average duration of less than one year.
What’s keeping most people away at the moment is the fear that the Federal Reserve will start raising interest rates, and that they’ll continue to rise. However, we have the capability to hedge that out. Let me say that while I do have an outlook on rates, I would put an investor’s capital at undue risk based on that outlook. Instead, we hedge to be rate-agnostic. We don’t want to benefit should rates fall, and neither do we want to get hurt if rates rise.
A slow, steady rise in rates is what will benefit discounts on closed-end funds. Retail investors worry most about uncertainty. The fact that the Fed is now approaching a rate hike and will likely slowly maintain that trajectory over the next few years eliminates that uncertainty, which is generally good for discounts.
Q: What is your investment strategy and process?
There are around 600 closed-end bond funds, of which 191 are municipal closed-end funds. The first thing we do is to look at historic performance of the funds across our universe on a NAV (net asset value) basis, because that is one aspect of the strategy over which fund managers have control.
We rank each fund company based on its NAV return and systematically analyze each fund to determine whether they contain difficult-to-value securities. The muni market is a little less of a challenge than taxable markets, but we search for any hidden tax gains or credit issues that could be problematic. We want to be comfortable with a fund. For example, on an aggregated basis, we have only 0.7% exposure to Puerto Rico because we want to avoid any potential bombs detonating in the portfolio.
The final step in the evaluation process lies in the governance of the underlying fund companies. This is where the municipal closed-end fund market lends itself to the whole strategy. Six major investment companies run 75% of the funds, dominating the closed-end mutual fund market, all with governance and all with policies and procedures in place. Larger funds tend to feature lower discounts than smaller funds.
In essence, we want to figure out what portion of their discount is deserved vs. what portion is irrational, so we revalue the funds and rank them on a combination of the yield we’re getting relative to the risk, and calculate each fund’s expected return. We have the ability to hedge out duration risk. We want credit quality that is single A, although we will go down to BBB average credit quality if there is sufficient reward.
The space is very similar to trading small-cap stocks—my traders all have small-cap equity trading backgrounds. A typical fund sits anywhere between $200 million to $2 billion in total market capitalization. There is sufficient liquidity and the market cap of the muni closed-end fund market is about $100 billion, spread across those 191 funds. Roughly $200 million worth of shares trade each day.
Someone hits the sell button on 50,000 shares of a closed-end fund almost daily without realizing they’re going to move the market. So, a fund that was sitting in the middle, or even at the bottom, of our rankings, suddenly rises to the top because the market cannot readily absorb a 50,000-share block.
The most gratifying part of our strategy, however, is the tender offer.
Q: How does a tender offer benefit you strategically?
Tender offers don’t move the overall market meaningfully. They only affect those who have their shares tendered.
That said, participation in tender offers is generally less than half, convincing me that retail investors must not read their mail. If a fund company does a tender offer, we’ll get taken out of at least half of our shares, but the reason we welcome it is because we can likely replace those shares in the secondary market at our original cost basis.
For example, we might have a fund trading at 90 cents on the dollar, but the fund company offers to buy back shares at 95 cents on the dollar. In one instance, a fund was willing to buy up to 20% of their shares. Only 25% of the shareholders actually tendered, so we got taken out of 80% of our shares. But we replaced the entire 80% at 90 cents on the dollar in the secondary market, before the tender offer even settled.
Q: Can you provide examples of your research process and how you look for opportunities?
One of the most interesting things going on in our space right now is the Nuveen merger. Mergers have to be done at NAV. Here we have eight funds consolidating into two, which means two funds are absorbing three funds apiece. When you have the surviving fund trading at an 8% discount and the funds merging into it trading at a 12% discount, this creates an arbitrage.
The magnitude of the Nuveen merger is so significant as to have a meaningful, durable impact on reducing the surviving funds’ discounts. They are essentially creating the two largest municipal closed-end funds on the planet!
From a historic NAV perspective, results have been ahead of benchmark and relatively positive. We like the portfolio management of these funds and the credit quality. They’ve all traded at a chronic discount and this big merger should solve that problem.
A second example is an Eaton Vance fund we like. It’s not trading at a discount but is trading at NAV, and has the best long-term record for one-year, three-year, five-year, and ten-year NAV returns. Historically it has traded at a premium, and we’re buying it at NAV because we’re comfortable with it. It tends to be a longer-maturity fund but we can hedge that out.
Q: How do you construct your portfolio?
We loosely correlate with intermediate municipal bond indices, not so much in the short term, because closed-end fund discounts have a different form of volatility, but we do tend to correlate over the long term. Our benchmark is the Barclays Intermediate Municipal Bond Index, which comprises bonds that have a maturity greater than one year and less than 10 years, and an average duration of about four years, although our duration is less than that.
The construction of the portfolio is predicated on how much we like the fund we’re buying and how liquid it is. If we loved all of the funds we currently hold equally, they would be weighted based on their average daily trading volume.
But we never love all our funds equally well. We could see as many as 60 to 80 positions but at the moment we have 35. We believe that as long as we confine ourselves to the top 30% to 40% of that universe that we believe are the most attractive, we’ll achieve good results in the long run.
From a hedging perspective, we aggregate all of the holdings of the underlying funds and break the funds down into 0–3-year, 3–6-year, 6–10-year, and 10-plus-year durations. To hedge the 3–6-year durations, we short the 5-year U.S. Treasury futures contract. For the 6–10-year duration, we short the 10-year U.S. Treasury futures, and for the 10-plus-year duration, we short 30-year Treasury futures.
Our objective, as I mentioned earlier, is to create a very large index fund. Right now, if you looked through the 35 funds we’re holding, you’d find about 5,000 bond positions across virtually all states, all revenues, GOs (general obligation bonds), some insured, some not insured, across the entire market. That is the plan.
We don’t look to outperform based on the underlying managers’ individual bond selections—we outperform by monetizing the discounts at which we buy the funds. Ultimately, we think a 4.75% tax-exempt yield with an A credit rating and less than a year of duration is a compelling value by itself.
Q: How do you define and manage risk?
Risk is defined on a variety of levels. We address credit risk by maintaining investment grade, which, while it doesn’t necessarily dodge all the bullets, dodges most of them.
One of the reasons the municipal bond market appeals over the corporate bond market is that bankruptcies and troubled situations, for example, the city of Detroit, are telegraphed in advance, sometimes years in advance.
There are two primary risks to our strategy. The first is the spread between municipal bonds and Treasuries. We are long muni bonds and short Treasuries to hedge out the duration. Right now that relationship is upside down. Pre-financial crisis municipal bonds typically traded at about 85% of Treasury bond yields, while today they’re trading at yields of about 110% of Treasury bonds. To put that in the context of a Treasury bond yielding 2%, pre-financial crisis a similar maturity municipal bond would trade at a yield of 1.7%, today it trades at a yield of 2.2%--0.50% cheaper than it used to trade.
While we recognize this presents a risk in any geopolitical crisis or any risk-off scenario, in the long run we believe it is an opportunity and will eventually return to its historic norm.
The other risk is that closed-end fund discounts could continue to widen. When we launched the fund, closed-end fund discounts were around 6.2%, which I thought were reasonably attractive levels, given that the 10-year average discount is about 2%. Unfortunately, by late August of this year, discounts had widened to 9.3%. Now they’re back to around 8%.
Historically, 9% has been the magic number for municipal closed-end discounts. Every time that has been breached, the fund companies themselves, and other institutional investors, quickly start buying shares.
We believe that finding municipal closed-end funds today at an 8% discount represents a significant opportunity.
