RiverNorth Core Opportunity Fund Review and Closed-End Fund Market Update - 9.10.2014
9.10.2014 4:15 PM ET
Allen Webb Good afternoon, everyone, and thanks for being with us for today's webcast. My name is Allen Webb, and I'm part of the portfolio specialist team here at RiverNorth.
For those on the call not familiar with us, RiverNorth is a boutique investment management firm located in Chicago. The firm was founded in 2000, and focuses on investing in closed-end funds, and volatility. In fact, we're one of the largest institutional investors in the domestic closed-end-fund market. RiverNorth is the advisor to five mutual funds, and the general partner to four partnerships that invest in these two asset classes.
Please contact me if you would like information on any of our fund offerings.
The purpose of today's webcast is to first discuss the current state of the closed-end-fund market, and highlight some of the potential opportunities. In addition, we will discuss the strategy and performance of our flagship mutual fund, the RiverNorth Core Opportunity Fund.
Today's agenda will consist of the following -- an introduction and a few quick announcements from me, followed by comments from RiverNorth's CIO, Patrick Galley. Q&A will follow Patrick's remarks. Q&A will be electronic only, and you may submit a question at any time, using the ask-a-question box in the bottom left corner of your webcast player.
Before we get started with the main event, I need to read a few standard risk disclosures on slide two. Please remember the fund's objectives, management fees, risk, charges, and expenses must be considered carefully before investing, and that the prospectus contains this and other important information about the fund.
Mutual fund investing involves risk and principal loss is possible.
And finally, past performance is no guarantee of future results.
I would now like to make a few announcements on slide 3. The most significant announcement is the RiverNorth launched an institutional share class for the RiverNorth Core Opportunity Fund in August. The ticker for the new share class is RNCIX. The new I-share does not have a 12(b)(1) fee, and does have a $5 million minimum. This share class should be available at all of the major independent platforms, and if you have any trouble placing a trade, please let me know, as soon as possible.
Next, if you like a copy of today's slides, please call or email me using the contact information currently on your screen.
Third, a replay of this webcast will be posted at rivernorthfunds.com in about two to four weeks.
And last, for those of you who are active in the social media world, you can follow RiverNorth on Twitter using the handle @rivernorthcap.
And with that, I will now turn over the webcast to RiverNorth's CIO, Patrick Galley. Good afternoon, Patrick.
Patrick Galley Great. Thanks, Allen, and thank you, everyone, for joining on the call today.
Before we dive into the fund, I always think it's a great idea to just give an overview of the closed-end-fund space, given it's such a significant part of our investment strategy. So, I apologize in advance for those that are on the call and have heard the story before, and understand and appreciate the inefficiencies in the closed-end-fund space, but for those that are new to it, I think it's very important to have a good understanding.
So, closed-end funds, for those that are not familiar, they are registered investment companies, similar to a mutual fund, and an ETF, an exchange traded fund. The major difference, though, is that they issue a fixed number of shares, and they go through an IPO process.
And the way they do that is they essentially go through a 30-day road show, typically there's a fund sponsor or a manager behind it, or not typically, but always. So, some of the fund sponsors could be a Nuveen or PIMCO, or one of our partners, DoubleLine, for example, has a couple closed-end funds. BlackRock is a big issuer of closed-end funds.
And they go a 30-day road show for a new strategy, typically going to the major wirehouses, and, for example, if they raise a fixed-income closed-end-fund strategy, and if they raise $1 billion there are hefty commissions that come out of that $1 that's raised, and typically it's around 5%. So, it's important to understand this IPO process, because that $50 million comes out of that $1 billion that's raised, and now you have a security that's only worth $950 million. So, when it gets priced, just like a regular stock, and it goes public, day one you now have a security trading at a 5% premium to its net asset value or the liquidation value of the underlying assets.
And from there, the only way you can buy or sell that security is through, typically, the NYSE, and most of us in the secondary market don't want to pay $1.05 for $1 worth of assets. So, that's where, really, the inefficiencies start, and that's also where RiverNorth comes in, in the secondary market.
Typically, the closed-end fund's market price, the price that you and I can buy it at in the secondary market, ends up trading at a discount to its net asset value. And RiverNorth's strategy is, obviously, buying-- being able to buy a dollar for less than a dollar.
So, for example, if we buy a closed-end fund trading at a 10%, simply, and that discount narrows to 8%, that's 2.2% of excess return above and beyond what the underlying assets did. So, it doesn't matter that the underlying assets went up or down, but we've generated 2.2% of excess return on top of those underlying assets. That's our definition of alpha, or excess return in the marketplace.
And it's important to know that the net asset value is calculated every single day, similar to a mutual fund. It's priced out at the end of the day by a third-party administrator. So, we know exactly what the underlying assets are worth every day. And we'll get into it a little later, but we take it a step further and estimate that net asset value intraday and try to take advantage of intraday inefficiencies.
So, the net asset value serves as an anchor. It's not like knowing what the intrinsic value of Apple is, or Google, et cetera. Closed-end funds, the net asset value is priced every single day. So, if it's trading at a 10% discount, you really do know it's a 10% discount. There's no question about that discount.
The closed-end-fund space by asset class, but starting at a high level, about 60% of the space are fixed-income or bond funds. There's $300 billion in the total closed-end-fund space, so $174 billion are fixed-income closed-end-funds. About 40% are equity or hybrid closed-end-funds. Yeah, that's $125 billion, and there are approximately 600 funds in total size.
The biggest asset class, though, or sub-asset class out of the fixed income are municipal bond closed-end funds. So, about half of the fixed-income space are municipal closed-end funds, almost -- about $80 billion worth. And you can see the diversity here on this chart over all the asset classes.
So, what's great about the closed-end-fund space is here at RiverNorth we can create a very diversified portfolio, and we don't have to get hung up on individual security selection. The individual security risk, and, frankly, the sector risk is diversified away when we are creating our portfolios. We are left with asset-class risk, but believers in modern portfolio theory, we believe that diversity does help reduce risk over long cycles.
Here's a chart on IPO trends over the past few years, going back to 2007. You can see, in 2007, that was actually a record year for closed-end funds. 40 new issues came to market. $28 billion were raised in a $700 million average.
2008 you can see, you know, it's very cyclical. IPOs come out with market sentiment. And so, when the market crashed in 2008, only two closed-end funds came to market, and a measly $131 million average raise in 2008.
But since then, 2009 to 2012 and even 2013, the closed-end-fund space has been rebounding from an IPO perspective, and we've had a nice little run. That all dried up in 2013 in the second half, post taper talk, and we'll get into the impact of what that had on discounts. But you can see, really, sentiment is a big factor in IPOs of the closed-end-fund space.
To date, year to date in 2014, four closed-end funds have come to market. Three of those four have been MLP closed-end funds. MLPs have historically traded at premiums to their net asset value. That recently has not been the case. A lot of the historical premiums in the MLP space have now gone to significant discounts, but yet they're still issuing MLP funds, and we think that might be an area that's getting saturated, although there is one fund in the market this month.
And then the fourth closed-fund that came to market in July was a biotech closed-end fund, a healthcare fund, and they raised almost $800 million, which is a very good raise. So, I think that's a very positive occurrence for the closed-end fund space that this is the first equity fund that we've had in a very long time. It was a significant raise, $800 million. So, I think that's very positive that we're getting away from the historical fixed-income trends that we have from 2009 to 2013, because most of those funds that have been issued were all fixed-income funds as everybody was reaching of yield. Because of the leverage that a lot of closed-end funds implement in their capital structure, there's typically higher yields associated with closed-end funds, and so they were easy to sell at IPO.
Here's a quick snapshot of just the closed-end-fund space. The average yield as of August 31st, 2014, was 6.3%. This is actually down from last, almost at 7%, which is-- it's interesting to note here that the yields are down, but that's most because the net asset value or the underlying assets have appreciated some.
From August 31st, credit spreads have narrowed, rates have actually come down, and so, even though discounts have lightened out, that's actually brought yields down, still, because of the net asset value appreciation.
Trading at a discount -- 91% of the whole space is trading at a discount, not a very big difference from last year, but if you went pre-May 2013, approximately 35% of the space was actually trading at a premium, so, this number would have been 65% trading at a discount. So, quite a shift in just about 18 months due to the taper talk and interest rate fears.
And you can see that trend here on this chart. This-- the blue column, is the August 31st, 2014; reds, 2013; and green is 2012. We wanted to add 2012, because I think it's important to note the big change from 2012. Because not really much has changed from last year, again, but you can see almost half of all the asset classes in August 2012, they were trading at a premium to their net asset value. I think it's 7 out of the 16 asset classes, and now, today, we only have 1 asset class trading at a premium to their net asset value.
But a couple asset classes to point out -- high yield, investment grade, municipal bond funds, preferred funds, really all the fixed-income asset classes, those are all the high premiums in 2012, and now they have had significant moves down. Again, that's all related to interest rate fears.
Another asset class to point out -- senior loan funds. They were trading at a premium, even though they're floating-rate securities, so their yield will actually increase if short-term rates do go up. You know, I think a lot of people lost faith in that concept. As rates went up, their yields didn't go up, because they were actually on the short-term end of the curve. And so, those discounts have now traded to significant discounts, as well.
And then the one-- the multi-sector bond fund, the one asset class still trading at a premium, it's worthy to note that that's being skewed, probably, that a handful of closed-end funds that are trading at astronomical premiums. For example, there's a PIMCO fund trading a 50% premium to its net asset value.
That's right, people are willing to pay $1.50 for $1 worth of assets. Even though that doesn't make fundamental sense, it still exists in the closed-end-fund space, and just another sign of the real inefficiencies in the space.
And the last thing to point out here on this slide, the covered call asset class is the only asset class that has narrowed from its 2012 discount level, and that-- the covered call funds are equity-based strategies, but they do have attractive yields in the closed-end-fund area, and so, I think a lot of investors, as they lost faith in fixed income and afraid of fixed income, they started shifting to covered call funds. So, we've seen some significant moves and discount narrowing in that sector.
Here's just a quick overview of the whole closed-end-fund space. Current average discount -- this is municipal bond closed-end funds, taxable fixed income, and equity closed-end funds, so the whole, entire space, the almost 600 funds, just wider than 7%. So, again, in line with last year, but a little wider, but a lot wider than the 3-year and 10-year average. So, we, again, attribute this discount widening to the interest rate fears in the marketplace.
And this gives you-- this chart on the left gives you a perspective of kind of where those discounts are. About 75% or over 75% of the funds are trading at a wider discount than 5%.
That's, you know, not much stiffer. It's still more than last year, but if you were to go back to 2012, again, that number would have been significant lower, probably in the tune of about 45%
To the premium side, less than 10% of the whole closed-end-fund space is trading at a premium, and, again, about 35% of the space was trading at a premium in 2012.
Mentioning 2012, because, obviously, 2013 not a lot big shift from there.
The right side-- the chart on the right side you're going to see here from 2009 to 2012 we actually had quite a bit of complacency in the market, you know, almost about 30%, on average, were trading at premiums to their net asset value. So, investors were willing to pay more than a dollar for a dollar worth of assets.
And, again, that makes no fundamental sense, but because closed-end funds have very attractive yields, the investors were attracted to it, and, frankly, about 95% of the whole closed-end-fund space is made up of retail investors, and a lot of retail investors are not looking at what's going on from a discount/premium perspective, what's going on in the underlying assets. They're simply just looking at the yield. And so, the complacency in the marketplace over 2009 and 2012 drove a lot of those funds to premiums. And, again, that's all changed in 2013 to 2014.
Now we-- there's more funds trading at a discount, going all the way back to 2008 and 2007.
I always like this chart. This gives you a perspective on the sentiment in the closed-end-fund space. You know, in a perfect world, this would be, you know, a nice bell-shaped curve, where we log each day's closed-end fund going back to 2003.
And you can see here, there's a fat tail to the left, and that fat tail to the left is each day's closed-end-fund discount, mostly in 2008 and 2009.
Today we're about a 7% discount, and so what this means only 279 days have discounts been wider than where they were as of August 31st. So, less than 10% of the days have been wider than where we are today.
Now, if you go all the way to the right, there's not really the fat tail to the right, and that makes a lot of sense, because that's, obviously, on the premium side of the equation, but it's worthy to point out where it is hitting that 1% in premium levels, that is mostly third and fourth quarter of 2012. So, we went from one extreme to another in a very short period of time.
In the third and fourth quarter we were trading at premiums, and then post-May 2013 shifted completely to the other side of equation, went from greed to fear in about a nine-month period of time.
Here we've got a long-term perspective on discounts, and you can see the volatility of the discounts, and so, you know, volatility of discounts is very important to us. It gives us the trading opportunities to go between closed-end funds and ETFs, which we'll get into in the strategy.
But because, again, 95% of the space is owned by retail investors, they are driven by fear a lot of times, and so, because the discounts are driven by supply and demand, as more investors sell over that fear, and there's not the same amount of buyers, the discounts are getting pushed out.
So, you can see various events here -- Lehman collapse or the financial crisis, you know, discounts hit 27% on average. That's, essentially, a seven-standard-deviation event. It shouldn't occur, but it did, and that was simply, you know, everybody was forced selling, a lot of fear in the marketplace.
That's an environment that's obviously very, very unlikely to happen again. Here at RiverNorth, we actually hope it happens again, because, again, that volatility, because you know what the closed-end fund is worth, it gives you the comfort to be able to buy as those discounts are widening out. Again, this is not like Apple's going down, this is purely the discount widening out from the underlying assets.
In scenarios like that, a lot of times you can get what we would call a double discount. The underlying assets are selling off extremely, but also, on top of it, the discounts are widening out.
And going all the way to the right, you can see the Fed Funds taper talk. We were-- we just hit a premium for the whole closed-end-fund space slightly in 2011, and-- or, I'm sorry, 2012, now we've trailed off. And here's a closer look of that. This is equity closed-end funds versus fixed-income closed-end funds.
So, you know, equity-based closed-end funds have really just stayed wide, between the 5% and 7.5% range or 8% range. You know, not a lot of positive towards equity-based securities.
Fixed income, alternatively, was, obviously, trading a premium to their net asset value, hit almost a 3% premium, on average, and then, with the taper talk in May-June of last year, immediately interest rate fears instilled in the investors, and discounts widened out.
So, in a very short period of time, we went from a 2.5% premium to a 7.5% discount, a discount widening of 10%. That's pretty extreme, and those are the type of environments that we like to see. Frankly, there was just too much complacency in the marketplace in 2012, and pre-May 2013.
One of the biggest questions we get from investors is, you know, obviously, there's a lot of sensitivity to interest rates increasing. And this chart, I think, rhymes a lot with what we're going through right now. This chart is from 2003 to 2006, and it gives you a historical perspective on what occurred in the last interest rate hike. And, what I mean by hike is the Fed Funds increasing in 2004.
So, you can see here the green line is the discounts back then for fixed-income closed-end funds. The blue line is the 10-year Treasury yield, and the red line is Fed Funds, and then the purple straight line is the current discount level.
So, as the Fed was looking at raising rates, the interest-- the discounts widened out quite drastically, went from about a 1% premium to an 8% discount, so widening of about 9%. That's very similar to what we just saw with the taper talk, widening out about 10%.
We-- and, again, this was just all because of the fear of interest rates rising. When rates actually started to rise, what occurred is discounts started to narrow. Now, there was a choppy road, which volatility is actually a good, positive thing for us to trade around, and, again, we'll get into the trading strategy in a little bit.
But, at the end of the day, you know, discounts ended up at 2%. What's most important, if you look all the way over to the right, the red line crosses the blue line. So, Fed Funds is actually higher than the 10-year Treasury yield. We call this an inverted yield curve, and this is actually a very-- I would call it a very poor fundamental picture for closed-end funds. Because closed-end funds implement leverage in their capital structure, they typically borrow short term, and they invest longer in the yield curve, and they have that carry trade.
Well, in an inverted yield curve, that trade doesn't work very well. You could have negative carry in that situation.
So, I would call this a very poor fundamental picture, but the reality is, discounts were still just a measly 2%. So, the closed-end-fund investment community didn't even get the fundamentals of it, but they were very reactive, just to the fear over interest rates. So, I think the takeaway from here is, you know, investors, a lot of times, over-react in the closed-end-fund space, which presents opportunities for us to take advantage of.
So, with that, let's dive into the fund. So, the Core Opportunity fund, that is our flagship fund. It was launched in 2006, and has actually been soft closed since July 2011. So, RNCOX is the retail share class. As Allen, mentioned, we did recently launch RNCIX, our institutional share class, that has a minimum of $5 million. We are keeping the retail share class soft closed at this time, but, hopefully, you can see from the opportunity set that we just went through in the closed-end-fund space, you know, we think it is a good time to take on more capital.
And it's important to us for the capital that we take on to have an investor base that's buying a strategy versus buying a track record, and what I mean by that is, typically, closed-end-fund investors are selling. RiverNorth wants to be buying into that weakness as those discounts are widening out. So, it's important that our investor base understands that strategy, and, in fact, is-- if discounts are widening, they're more apt to allocate more capital than take away a capital. So, we want them running away from the lemmings versus running with them.
The strategy itself is a balanced fund. So, you can think of it as, at a high level, I hate to use it, use the reference, because it's never a 60/40, but at a high level, it's a 60/40 fund between equities and fixed income.
So, this is our most flexible strategy. It's the strategy that gives us the ability to invest in all asset classes of closed-end funds, but you boil it all down, the risk profile we try to keep very consistent, because if we don't, and we move the asset mix around quite a bit, and the risk profile of the fund, from an asset allocation perspective, that can destroy the alpha that we're trying to generate in the closed-end-fund space. So, we maintain an opportunistic between closed-end funds and ETFs.
A lot of investors don't understand when they're looking at the fund why the fund consists of closed-end funds, ETFs, and cash, and it's not all closed-end funds. It's very important to understand that we have utilized ETFs as a tool for us to lock in alpha or excess return.
And so, going back to the earlier example, if we own a closed-end fund at a 10% discount and that-- let's just say that closed-end fund is highly correlated with the S&P 500 and it owns equities, and if that discount narrows to 8%, we want to be able to sell the closed-end fund and not necessarily time the equity market.
So, we'll buy a similar ETF. Let's just call it the S&P 500 index. And so now, we've locked in 2.2% of excess return from that discount going from 10% to 8%.
So, now, if that discount goes back out to 10%, we can sell the ETF and buy that closed-end fund again. We've maintained the same asset class exposure or market exposure, but we've locked in 2.2% of excess return, and we get to do it all over again.
And you can see that if occurred, that type of volatility five times in a year, which is unlikely, but it gives you the perspective that more volatility is good for us, if that happened five times a year and you add up that 2.2% times 5, you now have 11% of alpha while owning an asset that's at a 10% discount to its intrinsic value. We think that's a very good risk-adjusted return versus betting on individual companies and sectors.
And so, that's-- that's the basis of the strategy of the RiverNorth Core Opportunity Fund, maintain a balanced profile, but extract alpha or excess return from trading around discounts inefficiencies in the closed-end-fund space. And, believe it or not, our philosophy at RiverNorth is that we believe the markets are relatively efficient, or even are efficient, but closed-end funds, because of the IPO process, who owns them, i.e., mostly retail investors, there's a lot of irrationality in the structure, or the investors, and given the structure of a closed-end fund, you know, that provides inefficiencies that we're able to exploit.
So, how do we implement our closed-end-fund trading strategy. We really-- we try to bucket our trades three different ways, because if you're new to the closed-end-fund space, you might look at some closed-end funds and say, wow, you know, buy the S&P 500 at a 15% discount to its net asset value. So, invest a dollar -- or I should say, invest 85 cents but get a dollar worth of assets.
You will become extremely frustrated, pretty quickly, that that discount doesn't narrow, because you're expecting to get your dollar back. And so, we try to always attach a catalyst, and say, why is this discount going to go from 15% to 12% before it goes to 17%, and, again, a lot of times you'll see just discounts trading at wide levels, and never really move.
And so, the first bucket is statistical analysis or mean reversion trading. We try to look at closed-end funds on a relative basis. So-- and the discounts of those closed-end funds. And what I mean by that is, if a fund's typically trading at a 5% discount and goes to a 10% discount, that's probably-- that's going to be more relatively attractive to us, than a closed-end fund that goes from-- consistently trades at a 14% discount to a 15% discount.
Now, we like, obviously, absolute wide level of discounts, but when we have absolutely level wide discounts, we're probably just going to have more closed-end-fund exposure in our strategies. But the trading of the closed-end-fund space, we like the relative movement of the discounts.
The second bucket are corporate actions, and so a lot of closed-end funds have company-specific news or actions that create an inefficiency that we're able to take advantage of. Probably one of the most common inefficiencies out there, from a corporate action perspective, are tender offers. And this is where a fund has agreed to buy back part of the shares at net asset value, or close to net asset value.
So, for example, if a fund's trading at a 10% discount, and they buy back 20% of the shares, that's 2.2% if you just participate of excess return. Now, the reality is, because the shareholders -- again, 95% of the shareholders are retail-oriented investors, you can imagine the proxy material coming in the mail to these investors, and it gets thrown in the garbage.
So, this creates an inefficiency for us. When they don't participate, we get their excess shares. So, if 50% of the shareholders end up participating in a tender offer, that 20% tender offer ends up becoming a 40% tender off to us. So, we're able to get more of our shares back at net asset value, because of other investors not participating. And, literally, I'd call that, you know, free money that all they had to do is read their proxy material.
But some other corporate actions that are out there are fund mergers, rights offerings, so funds that are issuing new shares, typically at a discount, to attract investors in the fund. Shareholder distributions, dividend cuts, dividend increases, funds that are converting to open-end funds, and even liquidations.
And also -- you know, I would also say IPOs, after they go public, a lot of times there's an inefficiency of just how they trade. Sometimes the IPO investors will overreact, and over-sell the fund, as well.
The third bucket is shareholder activism. So, this is where RiverNorth doesn't consider ourselves an activist, but, rather, we look at other institutional investors that are out there that-- you know, call it that other 5% that owns the space. And they might increase their share position in a closed-end fund, willing to go to the mat or fight, if you will, the board of a closed-end fund.
So, each closed-end fund has its own board of directors. That board of directors has a fiduciary responsibility to the closed-end fund investor, not the fund manager. And so, if you have a fund trading at a 15% discount where it can be liquidated tomorrow and everybody would be 17.5% richer, if you do the math, you can see why there's a-- you know, there's a conundrum at the board level.
So, some shareholders will increase their positions in closed-end funds and go to the mat and potentially have a proxy contest, if they need to, to extract that value in the closed-end funds. So, we have a-- we at RiverNorth trade around the shareholder activism opportunity, as well.
And then the-- one other catalyst, if you will, if and it's not really a catalyst, but the other benefit of investing in closed-end funds, is that if you do own them at a wide discount, and they do have a distribution, there is enhanced yield. So, I would add that as kind of a fourth benefit to trading closed-end funds is that, if you own a closed-end fund, again, let's just say it's at a 15% discount to its net asset value, you're going to get 17.5% more yield than you would if you owned those underlying assets directly. Now, that's simply because you own those assets at a 15% discount to its net asset value.
So, we're-- we are getting paid to wait with excess return for a lot of these wide discount scenarios.
The current positioning of the fund, of the Core Opportunity Fund, the two charts is current and the top-- or, excuse me, the bottom two charts are August 2013. The asset-- the investment vehicle allocation, we are 62% closed-end-fund exposure, 23% in ETFs, and 15% in cash, as of August 31, 2014.
This is not a very big difference from last year, but what these charts don't tell, because they're just a point in time, is the path of going from 62% to 61%.
We actually took the 61% up all the way up to 85% in December 2013. We were in the middle of tax loss selling last year, and also off the heels of interest rate fears, and discounts widening out quite a bit. So, a lot of investors in the closed-end-fund space were sitting on large losses, and there's a fourth quarter phenomenon that usually takes place, which is tax loss selling, and investors are notorious in the closed-end-fund space for harvesting those tax losses. Because there's so many muni closed-end funds in tax-sensitive investors, I think that's spilled through to all closed-end funds.
But this provides a nice tactical imbalance that we're able to take advantage, and so, we increased our closed-end-fund exposure up to 85%. Since then, we've brought that exposure down to 62%.
And the 15% cash and cash equivalents, it should be noted that that doesn't mean we're bearish on the space. That's actually pretty common. So, we typically have-- you know, it's not uncommon for us to have 10% to 20% closed-- excuse me, cash in the portfolio at any point.
What-- number one what this does is it offsets the leverage that a lot of the closed-end funds are taking on. So, if a closed-end fund has a dollar but they're-- they borrow 30 cents, we now have $1.30 of exposure. So, we're able to keep some cash on our balance sheet, but yet still be fully invested.
And then that cash becomes our dry powder, our liquidity source if we needed it, and in this type of structure, we're never forced to sell closed-end funds if we have a redemption. So, I think we have an advantage to separate accounts out there. A lot of investors get frustrated by trading the closed-end-fund space, and this ends up becoming an advantage to us.
And so, actually, while we're on the topic of trading closed-end funds, you know, RiverNorth is considered that outsourced analysis, portfolio construction, but then, most importantly, trading, because a lot of investors in the closed-end-fund space are frustrated in trading closed-end funds, and the way we look to trade closed-end funds is we trade off of discounts.
And we've created our own proprietary execution management system, currently called Auto Trader (ph), but we're getting away with the name-- getting away from the name Auto Trader, because it's not a black box. It doesn't automatically trade.
What it does do is, it estimates the current discount on an intraday basis, and our traders are able to put in a target discount level that we're willing to execute on, and to the extent that that discount is hit, then we're executing.
So, it's not a black box that's generating ideas, et cetera. It's purely just an execution management system to trade off of what I would call limit discounts versus limit prices.
But, from that standpoint, if anybody has a better than Auto Trader, we're willing to listen.
Changing gears, on the asset allocation, on the right side, you can see we're quite diverse over various asset classes. Equity -- our equity allocation is 55%. This is slightly down from 57% last year, so not much has changed. Hybrids has come down, as well.
The reason that exposure has come down is because our fixed-income exposure has increased, and with that fixed-income exposure, we have some risk-based assets, so assets such as high yield that might be correlated with the equity markets.
And so, what we try to do is manage the overall beta profile of the Core Opportunity Fund to about 0.55 to 0.65 to the S&P 500, and that's on a look-through basis to each closed-end fund, including the leverage, et cetera. So, it's, again, why we-- we typically have higher cash on our balance sheet.
And this gives you a circle perspective on our closed-end-fund allocation. You can see here in December 2013, we did ramp it up to about 85% closed-end-fund exposure. This is the most closed-end-fund exposure we've had since October 2008, and the chart doesn't go back that far, but, you know, we view this as, again, a nice technical imbalance after the complacency that we saw from 2009 to 2012, it was an opportunity to increase our closed-end-fund exposure, and, as the tax loss selling season was over, and we were obviously in a new year, we started to bring that down, harvesting some of the alpha that we've generated in the strategy.
Here's a chart that shows us a snapshot of the asset allocation of the fund at the end of the year, going back to 2008. And the gray box is our strategic asset allocation. So, in 2006, when we launched the fund, we wanted a home base, so, we can kind of base our asset class moves. We're-- what we are never is the strategic asset allocation, but it still gives us a home base of an optimized, risk-adjusted portfolio on the mix of asset classes that gives us the best risk-adjusted return.
That said, again, we're never that strategic asset allocation. But what the takeaway should be from this slide is that we're not trying to market time asset classes. Now, closed-end-fund discounts will lead us in certain directions but, ultimately, with correlations of asset classes, we're able to counterbalance the risk in the portfolio somewhere else. And, overall, the 0.55 to 0.66 beta is pretty consistent throughout various market cycles.
Performance for the Core Opportunity Fund has been strong since inception. It's a four-star fund. It's currently in the 14% percentile for the past five years and we can see the fund's up about 8% year to date. That's in line with a 60/40 blend, trailing the S&P 500, which we would expect when the market's up significantly.
And then, the closed-end-fund index, that's our proprietary index that we've created, and we wanted to create an index that's unbiased to various discounts in the closed-end-fund space. So, this has about a 0.98 correlation to the whole taxable closed-end-fund space, so, we think it's very representative of the closed-end-fund space.
What we're not trying to do is beat the closed-end-fund index. We expect, when asset classes are up, are positive, that the closed-end-fund index should outperform us. And, you know, a lot of that has to do with the leverage of the underlying assets.
In addition, you have positive sentiment, and those discounts are narrowing. So, our job with the Core Opportunity Fund is manage the risk-adjusted returns, manage the probability of discounts narrowing before they're widening, and, as, you know, you'll see in a little bit, you know, volatility of those closed-end-fund discounts can get quite exacerbated.
The since-inception return is 9%. That's almost 300 basis points higher than the 60/40 blend, and, obviously, higher than the S&P 500, and then the closed-end-fund index is the laggard in the group of 5%. At lot of that underperformance has become-- was from 2008 because of the volatility of discounts and underlying assets. And so, again, risk-adjusted returns is what's paramount to us.
And speaking of which, this is a nice slide that illustrates that. Our volatility is approximately 14%, or our standard deviation for the fund is about 14%, compared to almost a 19% standard deviation for the whole closed-end-fund space. So, the purple circle.
So, a lot more-- a lot less volatility than the closed-end-fund space, less than the S&P 500, but yet our return is approximately a third higher. So, risk-adjusted returns is what we're shooting for, high Sharpe ratio, and with that, we need various market cycles. The past three years or, let's call it, 2009 to pre-May 2013, did not help because of the complacency in the closed-end-fund space.
So, now we think that complacency is no longer here, and, obviously interest rate fears are here to stay, as well, so, we like the choppiness that we think we're going to see, going forward.
Piecing our performance on a year-to-year basis, you can see, we never are going to be your best performing fund in your asset mix. We shouldn't be. We're a very diversified, balanced, strategy aiming to hit singles and doubles by generating alpha through the closed-end-fund inefficiency.
That said, our performance going back to 2007 on a year-to-year basis, seven out of the eight years here shown or periods of time shown, we were in the top 50%. So, you know, you typically, you know, think we should be right around the middle.
2011 was an outlier where we lagged. We typically have 25% of our equity exposure in international exposure, which would include EM, as well, and you can see the underperformance there. So, that's more of an underperformance from our strategic asset allocation, rather than from closed-end-fund selection.
And 2009, coming off the heels of the volatility in 2008, you can see our performance was off the charts. We were almost the best-performing asset class, with the exception of emerging market, generating almost 80% return.
So, you put all those years together, on an individual basis, but you-- when you accumulate those singles and doubles, maybe, you know, the occasional triple, what this has done, since inception of the fund, we've generated, you know, the best performance relative to all those asset classes on a cumulative basis, with the exception of gold. And, you know, obviously, I wouldn't consider gold as a core holding for many investors, plus you're obviously going to have a much wilder ride just holding one asset class.
So, we're quite proud of this accomplishment over the-- since the inception of the fund, and I think it shows you the benefits of the diversification, and adding alpha from the inefficiencies of the closed-end-fund space.
And this slide shows us where that alpha has really-- you know, how it's come together since 2008, January 2009. The green line is our attribution from closed-end-fund discounts. The blue line is the taxable closed-end-fund space's discount over that period of time, and I think the takeaway here is that the closed-end-fund discounts were all over the map, we-- but, yet, we've consistently generated alpha.
Now, there's periods of time that it declined a little bit, and, you know, obviously, in the first quarter of 2009, there was a decline. Obviously, the market was quite drastic with discounts widening out, but that volatility ends up producing future excess returns.
So, again, to reiterate, we want volatility of discounts. That's our alpha source for future returns, because of investors over-reacting to the volatility in the marketplace.
But going back to January of 2009, or December of 2008, we've been able to generate 22% of cumulative alpha for the Core Opportunity Fund. If you divide that by the 5-1/2 years, you're about approximately 4% average annual alpha for the Core Opportunity Fund.
And I think one of the takeaways here on this slide, if you go all the way to the right, with the taper talk, and discounts widening out quite a bit, going from, let's call it, from 2% to about 8% in a very short period of time, we still were able to generate 2% of alpha over that period of time, and a lot of that had to do with the flexibility of the strategy.
We had equity-based closed-end-fund exposure, predominantly, in the portfolio. We had very little fixed-income closed-end-fund exposure, literally licking our chops, waiting for the shoe to drop, and fixed-income closed-end funds coming off the premium levels that they were trading at. And when that happened, we were able to rotate, and be able to take advantage of that inefficiency.
So, with that, those are my prepared remarks. We're going to turn it over to Allen to moderate some Q&A.
Allen Webb All right. Thanks, Patrick. We have quite a few questions here in the queue, so, I'm just going to take them in the order that they came in. Obviously, you touched on pieces of a couple of them, but we'll just ask them, and get some additional comments, in case you've touched on it before.
So, question number one, and this is-- dovetails nicely with the very last slide. Can you give some idea of how each of the following factors have contributed to performance -- tactical asset allocation, security selection, and narrowing of spread between market price and NAV?
Patrick Galley Yes, so the attribution of a closed-end fund and our strategy, you can imagine, is quite the task, and we have an analyst dedicated to doing that, and it's excruciating trying to bifurcate all the pieces to the equation.
So, the tactical asset allocation, and the security selection, I would actually combine those two, and, you know, security selection for us, if you just look at the net asset value, we're not investing in closed-end funds for the manager's skill, but rather it just ends up becoming asset class exposure to us, because you start putting a lot of these funds together, the manager's skill is diversified away, or lack of skill, even. Some get lucky or unlucky.
So-- and the tactical asset allocation is, hopefully, you can appreciate we're not necessarily trying to time asset classes, because that's a-- we believe that's a riskier bet than timing discounts. So, we're trying to just maintain an asset mix that gives us a more consistent risk profile.
So, what that leaves us with is asset class exposure, a more consistent beta, if you will, and the discount narrowing. And the last chart that I did show, you know, we've been able to generate, you know, 22% or about average annual about 4% of alpha in the Core Opportunity Fund.
Allen Webb All right. Question number two. How do you manage the illiquid nature of the closed-end-fund space with regard to new asset addition and liquidation in the mutual fund?
Patrick Galley Yeah, that's a great question. You know, inflows and outflows of the Core Opportunity Fund, it's-- I think it's a strategic advantage to have our strategy in a fund structure, because we're never forced to buy closed-end funds. We're never forced to sell closed-end funds with those inflows and outflows, as if it was a separately managed account strategy.
And so, if there's not enough closed-end funds to buy at attractive discount levels, we can simply buy ETFs, if we have an inflow, or sell ETFs if we have an outflow, and all the while, you know, we're maintaining our market exposure.
So, we're able to take advantage of other strategies that might be out there that are forced to sell and buy, because of technical reasons, because of inflows and outflows.
And then, you know, to hit upon our execution management system, you know, that's important to us, as well, from a trading perspective, that we can set the level of discount that we want to buy and sell at, and do it very systematically at the discount we want. We never come in and say, we're going to buy this closed-end fund and push the price up.
We can say-- we say, we're going to buy this closed-end fund at X discount. To the extent it gets there, we're executing. To the extent it doesn't, we're not.
Allen Webb Question number three. Can you talk a little bit about 2008-2009 performance for the Core Opportunity Fund, and, in your opinion, do you need-- ultimately need that type of environment in order for the strategy to succeed?
Patrick Galley 2008 and 2009, that was very extreme closed-end-fund movements, and the discounts, I think you saw, was-- you know, there was one day that it hit 27%, on average. That was literally one day in October. It immediately bounced back.
So, what-- we don't need that type of volatility, for sure, nor would we expect to have it. That was really a pure forced selling.
But what's important that you have dry powder to be able to continue to buy into further discount weakness. And so, that's where management of our overall closed-end-fund exposure is very important. Typically, our closed-end-fund exposure is 50% to 70% of the fund, and with the rest being cash and ETFs. That gives us enough dry powder to be able to buy into discount widening. Because we never know when discounts are going to wide, when the next headline is going to come out, and fear is going to be there, and discounts go further and further.
So, we don't need that type of volatility. What we don't want is the period that we had, let's call it, you know, post-first quarter to 2009 to pre-May 2013, where there was, frankly, just a lot of complacency in the marketplace. And, you know, that's predominantly the two-thirds of the space being fixed income closed-end funds went to premiums to their net asset value.
And so, complacency is actually, you know, our worst market, and I don't think we're going to see that again, as well, just because of the fear over interest rates.
Allen Webb Got you. Also, right behind that, we have a question about equity versus fixed-income closed-end funds, and the alpha potential for each of those asset classes?
Patrick Galley Yeah, that's actually a great question. Fixed-income closed-end funds are our favorite asset class to trade, and the reason being is that the discount volatility is greater.
As you can appreciate, in 2008 and 2009, with the equity market selling off quite drastically, closed-end funds-- fixed-income closed-end funds were highly correlated with what was going on in the equity markets, from a market price perspective, even though the underlying assets might have been negatively correlated or, you know, slightly correlated.
And so, what that meant, the difference between the two, was discount volatility. So, that gives us a much better opportunity to generate alpha. And so, you know, that's, again, why we're quite excited about the environment that we're in now, and we think is here to stay for a while, if not for a very long time, if this is a secular trend in fixed income.
Allen Webb All right. Next question. We have a question about the credit rating of the portfolio, and I'll take this one.
As of 6-30, which is the last publicly released information on credit rating, the fixed-income portion of Core Opportunity was 54% below investment grade, and 46% investment grade.
Any comment to add to that, Patrick?
Patrick Galley No. I mean, that's-- we're-- if we do dial up our below-investment-grade exposure or our credit risk, that credit risk tends to be correlated with the equity markets, and so, that's where you would see us dial down our equity exposure and beta adjust the portfolio, again, trying to keep it more in a 0.55 to 0.65 profile. So, you, as allocators, know where to position it in the portfolio, and know what to expect from a net asset value performance, and let us handle the alpha extraction, and the closed-end fund discounts.
Allen Webb Patrick, someone had a follow-up question. On slide 19, which showed our asset class allocation, the-- each of the asset classes, when added up, totaled 117%. So, the question was, is the fund levered?
Patrick Galley The fund is not levered. The underlying closed-end funds implement leverage in their capital structure. And that's why you'll typically see a high level of cash in the portfolio, which will counterbalance the closed-end funds leverage.
So, we take that into consideration in our portfolio construction.
Allen Webb Great. A question about fees-- I'm combining a couple questions here about fees.
One of our listeners has commented on, he has seen-- he or she, has seen fees ranging anywhere from in the 130s all the way up to the 220s. So, can you talk about why there's differing numbers out there, and what do those mean?
Patrick Galley Sure. The expense ratio of the Core Opportunity Fund retail share class is 1.35%. The expense ratio of the institutional share class is 1.1%, so 25 basis points less.
The-- that's what I consider to be the expense ratio of the fund. And then, the fees that you're talking about that are in the 2% range, that includes the acquired fund fees that we're buying in the closed-end funds. But because closed-end funds are exchange-traded securities and the market price deviates from the net asset value, you know, we-- we at RiverNorth, you know, don't get too hung up on the expense ratio of the underlying funds, because, ultimately, we're trying to extract the difference between market price and net asset value to add our alpha.
The SEC, in our prospectus, requires us to include those acquired fund fees, and the irony of that is the more closed-end-fund exposure we have, the-- presumably the more opportunity we have, the higher our expense ratio we would have on a grossed-up basis. So, I would say, the higher you see our expense ratio, probably is an indication of more opportunity in our space, in an ironic way.
Allen Webb Great, thanks. Next question. One of our listeners has a two-part question on a couple of closed-end-fund sectors. One is, why are MLP closed-end funds trading at discounts? And then, number two, why have muni closed-end-fund discounts been increasing lately?
Patrick Galley Yeah. So, MLP closed-end funds trading at discounts, and I think you can probably throw in munis, as well, you know, both are yield-based securities, and this is really coming off the heels of the taper talk of last year, and the movement. It almost becomes self-fulfilling.
First, you add fear. A lot of these funds were trading at premiums, so high market prices relative to their net asset value.
The underlying assets, the net asset value, exhibited some volatility. That spooked the investors that were holding these securities, the complacent investors.
When they started selling, now you have more volatility, which is the market price coming down below, and discounts widening out, which spooks even more investors. So, that's the self-fulfilling part of the equation that the more investors that sell, the more volatility you have, the more investors you have that are selling, as well.
It ends up getting to a point of value, which I think we're at now, where a lot of these MLP funds are, you know, trading at high-single-digit discounts that, frankly, were trading at premiums, at one point. And the same thing with muni closed-end funds. A lot are trading at high-single-digits, even double-digit discounts that were trading at premiums at one point, as well.
I think, you know, once the fear subsides, and that fear might subside over interest rates when interest rates actually start to increase. So, that's the slide that we had earlier that you saw from 2003 to 2006 when rates started to go up, the fear was no longer there. Now investors felt more comfortable buying value-based assets.
Allen Webb Patrick, to reiterate that point, the next couple of questions are all about, number one, discounts still seem relatively wide. What would cause them to narrow, and then, do you care to comment on what a, you know, 1% to 1.5% increase in rates might do to closed-end-fund discounts, since they are levered?
Patrick Galley Sure. Yeah, you know, what will be the catalyst for them to narrow? You know, there's two ways to look at this. There's the security selection. There's also the asset class categorization, and then also, the whole closed-end-fund space.
So, you know, I think what you're not going to see, or I don't think you're going to see, is the whole closed-end-fund space go back to where it was trading, and, also, fixed-income funds go back to the premiums that you saw. Because, again, I think interest rate fears are here to stay.
What I do think you'll see is choppiness of those discounts. So, I think when you start to have some interest rate fears subsiding, you're going to start to see investors say, oh, I can, you know, get us 6.5% tax-free yield in the muni space, which is, you know, a double-digit tax equivalent yield. That's pretty attractive. I'm going to go there, and you're going to see those discounts start to narrow, until interest rate fears come into the picture again. And so, I think we're going to be in this ongoing cycle and choppiness of those discounts.
From a-- from interest rates going up 1% and 1.5%, number one, you have to say, where is that going to occur on the curve? Is it the short-term rates, or is it the longer end of the curve? And I think if it's on the longer end of the curve, like we saw in 2013, with rates going up over 1% in a very short period of time, you know, in 2013, the fund's performance, the Core Opportunity Fund's performance was up over 15%. So, obviously, interest rates increasing, the discounts widening, didn't impact the Core Opportunity Fund's performance that much. We're able to have the flexibility to manage our overall duration risk in the fund, et cetera, and not be exposed.
Where I think the bigger impact will be is when you see short-term rates increase 1% to 1.5%, especially if that happened very quickly, because then you're going to squeeze the carry trade that I was talking about before, where you might see the long end of the curve stay flat, but the short end come up, which is going to squeeze the spread for a lot of these closed-end funds that are implementing leverage in their capital structure.
So, we-- that's, you know, something that we look at, and to manage the overall closed-end-fund exposure, and our interest rate sensitivity for the whole fund.
Allen Webb Got you. All right. We're bumping up on about an hour here, Patrick. So, we're going to have a little speed round here on the last couple questions.
First question, can you talk about the difference between Core Opportunity and Equity Opportunity from a strategy standpoint?
Patrick Galley Sure. The Core Opportunity Fund, that's our asset allocation fund. Think of that as more of a balanced fund, equities and fixed income. The Equity Opportunity Fund is purely equity-based closed-end funds, and ETFs.
So, the strategy is very similar, but with the equity strategy, for those that have equity allocations to large cap, et cetera, that's going to be very similar to the Equity Opportunity Strategy, with a little lower beta than you would get just allocating to a large-cap growth fund or a large-cap value fund, for example.
But we don't allocate to fixed-income-based closed-end funds in the Equity Opportunity Fund.
Allen Webb Great. A couple questions about RNCOX and RNCIX from a structural standpoint. Number one, can you define a soft close for RNCOX?
Patrick Galley Yeah, RNCOX soft close means that current investors and advisors that are allocated to RNCOX can continue to allocate for their investors. So, even if they have new investors come in, they can continue to allocate, because the soft-close designation is at the advisor level.
And then, we don't have any plans to hard-close this strategy.
Allen Webb Great. A follow-up on that is, if I have over $5 million in RNCOX, can I exchange into RNCIX, and I'll answer that. The short answer is yes.
It is platform-specific into the actual logistics of how that happens. So, please let me know if anybody has that situation, but, philosophically, yes. With over $5 million in RNCOX assets, we will allow an exchange into RNCIX, all things being equal.
A question on RNCIX, Patrick. With your move to an institutional share class, are you anticipating more institutions, pension funds, and the like, to enter the closed-end-fund space? And then, the second part of that is, why have we not seen that happen, broadly speaking, so far?
Patrick Galley Yeah, to answer the latter question first, it's-- you know, to have an institution come in to the closed-end-fund space, and, first of all, manage that portfolio themselves, would be nearly impossible. I mean, you're going to have to construct the portfolio, monitor the portfolio, and trade the portfolio, and I think that would be very inefficient, and, frankly, probably create some inefficiencies for us to be able to take advantage of.
But with the launch of the institutional share class, I'll call it institutional share class, it's really, you know, that's our high-dollar minimum fund, but, you know, we will see institutions come into the space. We do have some institutional investors in our products. These are investors that understand the inefficiencies in the closed-end-fund space, and are viewing our alpha as unique and alternative, compared to what they can get other places.
So, you know, I don't think you're going to see a huge amount of institutional, true institutional, interest in the whole closed-end-fund space, because, at the end of the day, it's a unique animal. There could be, you know, more volatility at specific points in time. Our investors tend to understand that more, versus, potentially, some bureaucratic institutional investors' investment committees might not understand that and the uniqueness of the closed-end-fund space.
Allen Webb Got you. All right. With that, we're a little over our one-hour allotted time, so, we're going to call it a day there. I want to thank Patrick for joining us today. We really appreciate your prepared comments, Patrick, as well as answering all the Q&A.
I realize we have a large number of unanswered questions, so, I will do my best to get those answered in a follow-up email or call, once we finish today.
Again, if you do want a copy of the slides, please be sure to email or call me, and I'll get those to you by the end of the day today.
And with that, one more thing we'd like to add is, we are updating fund statistics for all of our strategies monthly on the rivernorthfunds.com website, so, even though our printed materials come out quarterly, we do update the statistics monthly on the website, so, please go to that if you have questions about portfolio positioning each month.
And with that, our time is up, and we very much thank you for yours, and we look forward to seeing everybody on a webcast down the road. Thank you.
The Fund's investment objective, management fees, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the Fund and it may obtained by calling 1-888-848-7569 or visiting www.rivernorth.com. Read it carefully before investing. To the extent comments conflict with or contradict what is in the prospectus, the prospectus should be relied upon.
Mutual fund investing involves risk. Principal loss is possible.
RiverNorth does not provide tax advice. Please see a tax professional to discuss your particular circumstances.
The Fund is distributed by ALPS Distributors, Inc. (Member FINRA).
Sharpe ratio measures risk-adjusted performance using the 90 day T-bill return as the risk-free rate.
As of 6.30.2014, there was no holding of Apple or Google in the RiverNorth Core Opportunity Fund. There is no assurance that any RiverNorth Fund currently holds this security.
RiverNorth Capital Management, LLC is not affiliated with Blackrock, Nuveen, PIMCO, DoubleLine Capital, LP or ALPS Distributors, Inc.
Allen Webb is a Registered Representative of ALPS Distributors, Inc.