Q: What is the history of your company and the Virtus Herzfeld Fund?
The Virtus Herzfeld Fund was launched on September 5, 2012 and specializes in a narrow field: investing in closed-end funds, or opportunities afforded by the Investment Company Act of 1940. Because closed-end funds have the ability to trade at premiums or discounts to their net asset value (NAV), they allow us to build a relative value portfolio that seeks to deliver both capital appreciation and current income.
We understand the closed-end space quite well. Our firm, Thomas J. Herzfeld Advisors, Inc., has had this same singular focus since it was founded by my father in 1984. Prior to the launch of the mutual fund, we offered retail investors direct access to our closed-end fund expertise only through separately managed accounts which require a high minimum investment. With the Virtus Herzfeld Fund, we extend access to a greater number of retail investors.
Q: How do you define your investment philosophy?
Back in the 1930s, Charles Keane, publisher at the time of perhaps the largest circulating market letter, argued that closed-end funds could never trade at a discount because they have professional management and that has perceived value. But, in fact, most closed-end funds do trade at discounts, and this is key to our philosophy: because closed-end funds are able to trade at discounts to their liquidation value, at some point they will trade at discounts.
Using this mentality, we aim to build a flexible portfolio that is balanced and has all the hallmarks of relative value. We do not have targets for yield or discount; we simply increase our investment level as opportunities present themselves.
With many closed-end funds, discounts persist for years; these are not investments we find attractive. For a position to be included in the portfolio, there must be a catalyst that will drive it back to par – back to its NAV. When there is value to be had, the discount will narrow, so it is crucial to understand what is driving the price rather than just buying anything that is at a wide discount.
Often discounts occur because of a particular type of environment, like the low interest rate climate we have been in for some time. Since 2010, yield has become dominant and is something that drives a closed-end fund’s discount to narrow. By definition, fixed-income closed-end funds can borrow at very low rates – LIBOR plus 70 basis points. This ability to borrow at low rates and invest in bonds yielding higher rates allows the fund to deliver a higher dividend rate.
Our objective is to not merely find discounted closed-end funds, but ones which are well run, where the portfolio manager can generate gains in NAV. We couple this with a timing process to buy funds at an attractive discount. Buying a closed-end fund at a discount gives us the opportunity to make money if nothing happens to its NAV or even when it decreases, unlike a mutual fund where no money is made if the NAV does not move, or if it goes down.
For instance, if a closed-end fund is purchased at a 10% discount and suddenly goes to a 5% discount, we would still come out ahead even if the underlying NAV of the fund dropped a few percentage points over that time period.
Q: What is your investment strategy and process?
Our investment strategy is based mainly on our deep understanding of the roughly 600 closed-end funds in this space. A few of them have actually been around since the 1920’s, and we have gotten to know them quite well over the years.
Instead of using a cookie-cutter approach, ours is more finely honed – we do more than merely read prospectuses. We know the funds’ boards and how they work, how the investment managers work, and whether there is high or low turnover, for example.
Our goal is to build a portfolio with diversified exposure. Though we do not generally express a strong view regarding what the Federal Reserve may potentially do, we do think about the type of environment the market is in, considering whether it is risk-seeking or risk-averse. This is typically exhibited through a fund’s discount or premium.
Closed-end funds have certain tax code advantages because any gains can be offset with losses. In an Initial Public Offering (IPO), a closed-end fund often goes to discount right at the start because certain fees go into the launch; the IPO price starts in one place but will gravitate lower. To get a sense for what is happening with tax-loss selling, we spend a lot of time on understanding the IPO market. Also, at the end of the year, seasonal patterns make investing in the closed-end space interesting.
Q: How does investing in closed-end funds differ from traditional investing, and where do you look for opportunities?
Closed-end funds can lever themselves in several different ways, including through lines of credit (LOCs) and preferred shares. Under the Investment Company Act of 1940, the type of leverage a fund uses dictates its asset coverage ratio throughout the life of the fund, establishing how much of its assets must be maintained to cover liabilities.
The preferred shares of a closed-end fund differ from traditional preferred shares, and probably are the least well understood of any of our investments – at least in the stock market. The majority of investors have not spent the time to understand these and are confused to the point that perhaps it would be better to call preferred shares by a different name.
Nonetheless, we benefit from this confusion. We are quite interested in buying preferred shares as they represent a strong value. We understand them, have significant holdings in them, and historically, our largest position has been in the preferred shares of Oxford Lane Capital Corp. A closed-end fund can issue a permanent security out of the balance sheet, which is what Oxford Lane did. It had an IPO and came to market with a coupon of 8.125% that expires in 2024, and a coupon of 7.5% that expires in 2023. These were issued at a par of $25 and pay coupons monthly. At expiration, we get back our $25 and all of our dividends. In actuality, these are cumulative preferreds. Thus, if for some reason Oxford Lane missed a dividend, it would have to pay it back in the end.
We think of preferred shares as fixed-income instruments and what attracts us is the yield, because not a lot of investments offer this kind of yield. When a traditional company like General Motors Company, Ford Motor Company, or Exxon Mobil Corporation issues a bond, it is only as good as its balance sheet. If their business hits the skids, it will affect how the bonds are going to trade.
Contrast that with a closed-end fund like Oxford Lane. Though its portfolio is diversified, there is a common theme: it is loaning money. Its underlying business is collateralized loan obligations (CLOs), and the firm’s management team members are experts in these debt instruments. The CLOs it buys are traditional corporate debt and senior loans.
The benefit we get by holding a preferred share in Oxford Lane is it gives us a lien on the portfolio. Oxford Lane has a balance sheet, holdings, and CLO instruments – and has to maintain an asset coverage ratio of 200% because of the way the Investment Company Act of 1940 works.
We buy these preferred shares whenever they are under pressure, meaning when they trade below par. If the common shares of the company end up trading lower, there is a correlation and the preferred shares will also go down. However, I think this happens because people do not understand that if a closed-end fund hits its asset coverage ratio, it is mandatory that the fund buy back shares or reduce its leverage. If the fund is trading at $22 and suddenly hits its asset coverage ratio, there is upward pressure on the preferred shares to go back to par because it will have to take those shares off the market.
This happened in 2008 to similar closed-end funds when the stock market was under duress. We were buying preferred shares at the discounted liquidation value, and a few days later they were going to par because the funds were required to reduce their leverage. Basically, we created a put on the stock market by buying these preferred shares – they offer an incredibly attractive yield and the lien is the portfolio itself. Most investors in preferred shares do not price in this put option.
Q: What is your portfolio construction process?
The Virtus Herzfeld Fund is widely diversified, with the single biggest exposure being to Apple Inc. at roughly only 1%. Looking at most equity investments, the risk exposure to any single name is closer to 5% or 6%.
The Fund has hundreds of positions and its breakdown changes frequently. Current holdings are 27% preferred shares, which also includes a bond; Eagle Point Credit Company Inc. has issued a debt instrument which is a bit higher in the capital structure than its preferred shares.
We like to keep extra cash on hand to be able to take advantage of buying opportunities as they arise. Right now we have 20% of the portfolio in cash, but that level has ranged from zero to as high as 25%.
The remaining half of the portfolio is in 27 closed-end fund stocks. Though these change, approximately 10% are currently in the healthcare space, where we have found attractive opportunities. Due to their cheap valuations historically, we have been able to buy them at a discount. In some cases, these funds have traded at double discounts, because the market discounted the healthcare company and then discounted the fund.
For instance, Gilead Sciences, Inc. is one of the healthcare stocks held by closed-end funds in our portfolio. Last year the healthcare market was under pressure; more recently, with the increased price of EpiPens, there has been avoidance of the sector by the investment community because of an impending law change.
This has pushed the valuations for healthcare stocks to historically low levels. A lack of demand in the underlying business translates to low demand for a closed-end fund that holds those stocks. As a result, there is quite a bit of discounting going on. We are buying Gilead at a 10% discount to where it trades in the market, and Gilead is probably already being discounted, trading at a P/E ratio of around 6.
We also have positions in fixed-income funds, in country funds including small positions in Japan and some European exposure, and exposures to Master Limited Partnerships (MLPs).
Our benchmark is a 60/40 benchmark consisting of 60% MSCI All Country World Index and 40% Bloomberg Barclays U.S. Aggregate Bond Index. Although having a benchmark is important to give a sense of how the Virtus Herzfeld Fund is doing, it is probably the hardest thing to pinpoint. We simply try to achieve 500 to 600 basis points over inflation, which we feel is a healthy return.
Q: How do you define and manage risk?
Many people think risk is only about how much money can be lost, but to us, it is about volatility – how much something can move. We look at risk as a statistical relationship, similar to a Sharpe Ratio or other risk-adjusted standard deviation criteria. Every instrument has possible pros and cons along with some type of investment trade-off – it is necessary to give something in order to get something.
For example, with the Oxford Lane preferred shares, we know we will not make 50%; however, we are seeking to get 650 basis points over Treasuries for something that is good in terms of risk with a potentially high Sharpe Ratio. Every bond has a lien through the company, or in this case, the lien is the portfolio itself.
Some of our other positions, like MLP funds, moved down last year, on average 50%. Because the risk/reward potential is so much greater, thus the portfolio will not have 30% exposure to MLPs. The Sharpe Ratio is simply not as attractive. The fact that we can potentially make 50% also means that we could lose everything because of the high level of volatility associated with MLPs.
We are trying to find the best relative value. If we know we will get 7.5% in an Oxford Lane preferred stock trade, why would we buy something else with greater risk for the same 7.5% reward? For instance, with an oil exploration company, we would want to have a lot more reward.
Each day presents certain risk and reward opportunities. All we do is rank them to see which offers the greatest reward potential for the lowest amount of volatility. With fixed-income funds, it is easier to do the math, and we use different criteria than we do for our equity funds. With equity funds, managing risk is more difficult and requires that we spend more time on the analysis of the discount/premium relationship than on the preferred shares. However, the reason equity funds are in the portfolio is because of the opportunities they offer. In some environments, the Virtus Herzfeld Fund will have a much higher concentration of equity holdings, and in others, more fixed income exposure.
Lately yield has been the most important thing, so that is what we position ourselves around. Because closed-end funds can actually lever themselves, there is an incredible amount of yield a portfolio like ours can get, especially through its fixed-income positions. Our due diligence gives us a good idea of what the Virtus Herzfeld Fund’s distributions will be.
We are firm believers in balancing risk and reward. For us, managing risk is front and center. Unless there is a worthy opportunity elsewhere, we want our money in cash – to us, cash is a call option on everything. Just by holding it, we are paying the inflation rate of 2% a year – and we do so in order to add optionality to the portfolio. Cash gives us the opportunity to buy everything at lower levels when the market sells off, and this is a critical component to our strategy. Most mutual funds tend to run with very little cash – some even have mandates to have no more than 3% cash. The Virtus Herzfeld Fund can be up to 100% in cash. If we do not see an opportunity because everything is trading at a large premium, we are not forced to buy something that could go down.
