ETF Expert Corner

Saba’s Leah Jordan Explains Closed-End Funds, CEFS ETF

June 19th, 2018 by ETF Store Staff

Leah Jordan, V.P. of Investor Relations at Saba Capital Management, explains closed-end fund basics and spotlights the Saba Closed-End Funds ETF (CEFS).



Transcript

You can listen to our interview with Leah Jordan by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: The ETF we're spotlighting this week is the Saba Closed End Funds ETF, ticker symbol CEFS, and joining us via phone from New York to discuss this ETF is Leah Jordan, Vice President of Investor Relations for Saba Capital Management. Leah, great to have you on the program today.

Leah Jordan: Thank you. Great to be here.

Nate Geraci: Leah, before we get to the ETF, I thought it might be helpful to do a quick sort of closed end funds 101. And it's interesting because we sometimes see closed end funds compared to ETFs, but of course, there are some important differences between the two. To start, can you just explain some of the basics of closed end funds?

Leah Jordan: Sure. There are similarities and differences between closed end funds and things like ETFs or mutual funds. It's a pool of investments, similar to an ETF or mutual fund. It holds a pool of either equity, high yield, some underlying securities, and it pays out dividends and capital gains distributions, similar to mutual funds. However, unlike ETFs or mutual funds, which can issue and redeem shares daily at the fund's net asset value, which we call NAV, closed end funds just issue their shares at IPO, and that don't have that issue/redemption mechanism. Instead, they trade intraday on the exchange at a price set by the market, similar to a single equity security.

Nate Geraci: And because of that, closed end funds can trade at either a premium or a discount. Can you maybe explain some of the drivers there, why that would happen?

Leah Jordan: Sure. There are a number of reasons that closed end funds can trade at a premium or a discount, depending on your net asset value. It depends a lot on investors’ perceptions, how they’re thinking about the market. And similar to supply and demand for the underlying securities, but also things that are specific to an individual closed end fund, can cause it to trade at a premium or a discount. Funds with higher expense ratios tend to trade at a discount to NAV, where funds that need special distributions and have a really high yield, investors tend to favor those funds and they can trade at a premium.

Nate Geraci: If I'm an investment manager and I have some sort of strategy I want to pursue, why use the closed end funds structure as opposed to say a traditional mutual fund structure? What's the benefit here?

Leah Jordan: Well, there are a number of benefits and closed end funds can fit into a portfolio in a number of different ways. First off, they can employ leverage. Closed end funds can be up to 0.3X leveraged, so the manager has the ability to lever up in times where securities are relatively attractive and they want to buy more of them. Another thing is unlike ETFs or mutual funds that have daily liquidities, closed end funds have the fixed number of shares and those managers are not forced to sell just to meet redemption requests. In times when markets are a little bit more bumpy, sometimes there's a little bit of safety in the fact that your manager can hold on to the securities in a closed end fund relative to an open ended fund.

Nate Geraci: Now before we get to the ETF, going back to the discount, why wouldn't an investor just always buy closed end funds at a discount with the expectation that they'll ultimately fill the gap back up to net asset value?

Leah Jordan: Certainly, that is what we aim to do here at Saba. We buy them at discounts to NAV. In terms of why any investor would want to buy at a discount, it is certainly the goal. There are people that buy at issue because they would like for a reputable manager like BlackRock or Blackstone or Western Asset Management, the issuer of these closed ends funds, to be actively managing a portfolio for them, especially in the high yield space. There's a view that these managers can add value. But of course, the idea of buying something at 90 cents on the dollar, if it's trading at a 10% discount, is very attractive. The thing you have to think about is, well, is that discount going to go from 10% back to NAV or is there the possibility, the risk, that it could go from 10% to 15%? There are a number of different ways you can view the criteria for screening these closed end funds, which we do here, that give you a sense for is this something that's going to naturally revert? If it doesn't, are there steps we can take to narrow that discount?

Nate Geraci: Our guest is Leah Jordan with Saba Capital Management. Leah, let's now look at the Saba Closed End Funds ETF, again ticker symbol CEFS. High level, walk us through the strategy here.

Leah Jordan: Sure. At a high level, we're buying closed end funds that trade at significant discounts to their NAV. We really get involved, sort of, in the double digit discount, both high yield underlying, fixed income underlying, as well as equity. We tend to focus on the fixed income space because the yields tend to be a little bit higher. And that's really the goal of the ETF is to have a product with a high yield. The distribution yield is about 8.3%. And then with that fixed income underlying, we wanted to hedge out the interest rate exposure because we think, especially retail investors right now, do worry about a rising interest rate environment. We wanted to take that piece out of the puzzle, and hedge the interest rate exposure of the fixed income underlying to really isolate the discount to NAV. And then what we do is actively manage the portfolio, both through trading, where one fund will go from a 10% discount to a 5% discount, we'll sell the one at a five and go buy another one at a 10 to generate some additional value there, as well as being an activist which is something that we've done a lot over the past year that's become more meaningful, just to monetize that discount to NAV.

Nate Geraci: Leah, can you explain that activist angle in a bit more detail? How exactly does this work?

Leah Jordan: Sure. Any investor could go out and buy a closed end fund trading at a 10% discount to NAV and hope that some reversion happens where that discount goes back to NAV or just moves up generally. But sometimes that doesn't happen. There are funds that have been trading at double digit discounts since 2013, and while you can sit there and hold it and you earn additional yields because bond math 101, something trading at 90 has a higher yield than something trading at 100. What adds value is that over time, the managers don't really want their funds trading at a discount in a lot of cases. They would prefer there be value in their name brand. We've had really a lot of success going to the managers of these funds and saying, "Look, you have the opportunity to do something shareholder friendly. Return value to your shareholders through a tender. Open end the fund, have it traded on NAV like an ETF. You can buy back shares. You can increase your distribution to make the yield higher”. And it's been really successful as a way to narrow that discount. There have been over 40 instances over the past years where managers have agreed to do something of that nature. That way, you have sort of a catalyst to get some of that value back from the discount.

Nate Geraci: Do you find the fund's management is typically fairly receptive, or do you ever have to use more heavy handed tactics to get them to get the shares back to NAV?

Leah Jordan: Certainly. I think our approach has been a bit more gentle, with tenders and increased distributions. In that sense, it's more of an amicable process. There are other activists in the space, sometimes even we've had to take the gloves off so to speak, to get managers to do something. But really it's about having the votes and we own over 600 million of closed end funds across our firm, so we're able to put the capital to work and buy enough of the funds to really have the vote and have a seat at the table with management.

Jason Lank: Leah, this is Jason Lank. I have a question regarding the liquidity of underlying closed end funds. Hopefully, it's not too technical. You mentioned earlier that closed end funds don't have a creation/redemption process. There's a fixed number of shares. But ETFs do, including yours. Are there any challenges for the authorized participants, whether creating or redeeming baskets, when they're dealing with closed end funds shares as opposed to say a very highly liquid Apple or Alphabet, something like that.

Leah Jordan: Sure. Right now, the fund is only 23 and change million, so it's not an issue that we would have at this size. If the fund were to get up to a billion dollars, and you were having to buy hundreds of millions or even less than that of one closed end fund in a day, yes, they're not as liquid as say Apple stock. However, we've found that because we're pretty well known in the space, and because we show up at the top of the holders list for a lot of these closed end funds, we do get benefits of increased liquidity, just because when there are blocks for sale, we get the first call. And so in that sense ... It's also, it's a diversified pool. The ETF holds 18 different closed end funds, so it's not as if you're going out to buy one. You can increase the number of closed end funds that you have in the ETF.

Nate Geraci: Leah, you mentioned the high yield of this ETF. I also wanted to ask you about the fund’s expenses. The ETF itself charges an expense ratio, of course. I believe it's currently 1.1%. But then the underlying closed end funds also charge fees. What does that typically look like for the underlying funds?

Leah Jordan: Sure. It depends on what the fund is holding, and also it just depends when the fund was issued. There are funds with very low expense ratios. There's a BlackRock High Yield Fund that charges less than 1% for BlackRock to actively manage your fix income portfolio, and then there are equity funds that charge 4% expense ratios. So that's part of our screening process, is all else equal, if fund A is trading at a 10% discount, and fund B is trading at a 10% discount, but one of them has a much higher expense ratio, we're going to go with the lower expense ratio. It's part of our modeling process. It also just depends on how much we turn over the book, because obviously a fund with a much higher expense ratio, if we have an activist play to do that, we would want it to be a shorter timeline than one with a 1% expense ratio. It really depends on what we're holding in the fund at a time. But those fees can vary pretty widely across the universe.

Nate Geraci: Again, we're visiting with Leah Jordan with Saba Capital Management. Leah, there are a handful of other closed end fund ETFs on the market. Right now, the most popular is the PowerShares CEF Income Composite. YieldShares has a product. If you were to perhaps boil this down, what do you view as the key differentiators here with CEFS?

Leah Jordan: There are a few. I think most of the other ETFs in this space are passive, and we think this universe, in particular the closed end fund space, the active management is very important because it's a very inefficient space. It's pretty fragmented. It's not as if the discount of the universe moves together. There are idiosyncratic moves of specific closed end funds that we can take advantage of and trade on an intraday or weekly basis because we have the flexibility of active management. We think that's really important. I think the interest rate hedge is something that will be appealing to people as they think about the rising interest rate environment, and would they rather hedge off that component. And then finally I think just our approach with activism and our proprietary models for ranking closed end funds. We don't just look at the quantitative aspects, like the yields or the discounts, that a lot of other models have the same inputs, but we also look at the qualitative factors. We've actually modeled out the language in all of the prospectuses for all 524 closed end funds. And so we look for the language in those documents that make them more appealing or less appealing and that's an input to our model as well. Just kind of gaining the access to our portfolio managers and their level of expertise in this space is a large part of why we launched the product.

Nate Geraci: Leah, we have just a couple of minutes left here. Where does the Saba Closed End Funds ETF fit in a portfolio? How should investors think about using this closed end funds ETF in the context of their overall allocation?

Leah Jordan: Sure. I think it's definitely income-oriented. I mean an 8.3% yield in this environment, I think, screams very attractively to people. There's a number of different ways you can think about it. If you want to be opportunistic, get exposure to some of this more active component, then that's another place it could fit in. We've seen people who look at closed end funds as a good alternative to their sort of vanilla high yield exposure at this point in the cycle, just because in more volatile times, closed end fund managers do have that flexibility and there's value to add there. If you are worried about a selloff in high yields or even something smaller than that - just a little bit more volatility in the space - wouldn't you rather have the head start of owning the portfolio at 90 instead of 100 because of that 10% discount. There could be a bit of a margin of safety there. That's kind of how we see it and the feedback we've gotten on the product. I think there's a number of different ways this can fit into an income-oriented portfolio.

Nate Geraci: About 60 seconds left here. Any time that you hear something yielding 8.3%, I think it's important to consider the potential downside or risk. What are the risks here?

Leah Jordan: You're subject to market risks, similar to open ended funds. If the NAV of these funds fall, then that's negative for the fund. Like I said, I think typically if you are worried about a selloff in the market, you would rather have the margin of safety of already owning it at a 10% discount or more. Other risks, the closed end funds themselves are levered, so there's that risk of leverage. The ETF has the ability to employ leverage, but we don't. Currently we're at 0% leverage. But I think those are probably the key risks considering the interest rate risk isn't there on this product.

Nate Geraci: Leah, we'll have to leave it there. Excellent spotlight today. Thank you very much for joining us.

Leah Jordan: No problem. Thank you.

Nate Geraci: That was Leah Jordan, Vice President of Investor Relations at Saba Capital Management. Again, the ETF is the Saba Closed End Funds ETF, and you can learn more about this ETF by visiting sabaetf.com.