Download Exploiting Inefficiencies Across Asset Classes, Globally

CITY OF LONDON
Investment Management Company Limited
Exploiting Inefficiencies Across Asset Classes, Globally
by James Millward & Michael Edmonds
Authorised and regulated by the Financial Conduct Authority. Registered as an Investment Advisor with the SEC. Regulated by the DFSA. Registered Office: 77 Gracechurch St. London EC3V 0AS
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Exploiting Inefficiencies Across Asset Classes, Globally
by James Millward & Michael Edmonds
We in the Global Developed & Tactical Allocation team have been focused on exploiting closed-end fund inefficiencies for over fifty years
in aggregate. The persistence and nature of these inefficiencies is unique to this investment vehicle, and one of the reasons we find our
niche so fascinating.
The global Closed-End Fund (CEF) universe offers more than $500 billion dollars of accessible market capitalization. CEF structures have
been used since the very earliest days of financial product innovation to wrap more than just equities, and in recent years the trend to use
these transparent, regulated structures to provide listed access to alternative, real and esoteric asset classes has accelerated.
This article seeks to highlight the benefits of looking outside a rigid benchmark-constrained approach, to access the broadest possible opportunity
set in our universe. At any given point in time, compelling value can be found in selected CEF subsectors and we believe institutional
investors, high net worth individuals as well as mutual fund and ETF allocators can look to closed-end funds for investment opportunities.
Our Investment Approach
Global Tactical Asset Allocation (GTAA) via CEFs offers investors three levels of market inefficiency to exploit.
First, at the underlying fund level there is the inefficiencies within the underlying asset class in which the CEF invests. The extent of these
inefficiencies will vary via asset class. For example, inefficiencies are likely to be small in a US Large Cap Equity but may be much larger
in say European Distressed Debt.
The second layer of inefficiencies is mispricing between asset classes. At any given time say US Equities may be richly priced while alternatively relative value may exist in say Emerging Markets Debt. The extent of these relative value opportunities between asset classes may
be considerable as asset classes go in and out of favor. In addition, the limited number of strategies which are looking across asset classes,
rather than within a specific asset class, may also increase exploitable inefficiencies.
The third layer of inefficiencies, unique to GTAA via CEFs, is the inefficiencies in the pricing of the CEFs themselves – the discount effect.
Such mispricing may be due to a particular fund being out of favor through poor performance, or may also reflect an out of favor asset
class amplifying the intra-asset class inefficiency. In addition, there may be relative value opportunities between CEFs in different centers.
For example, a Global Equity CEF listed in New York may be expensive while a fund offering similar exposure in London may be cheap.
The persistence of these three layers of inefficiency means considerable opportunity to add differentiated alpha via a GTAA strategy using CEFs.
Compared to passive or quantitative GTAA strategies, primarily using ETFs or derivatives, CEF-based approaches tend to be lower
turnover and more qualitative.
Not only are we seeking to exploit discount opportunities on sectoral and single-name bases, we are also conscious of the underlying portfolio performance. Further, the listed nature of closed-end securities means that event-driven situations (tender offers, liquidations, rights
offerings, special dividends, mergers etc.) can create significant value for shareholders.
Portfolio construction follows a simple three stage process against a “neutral point” of a hybrid equity/bond benchmark.
Macro Process (Top-Down)
Dislocations & Opportunities
Stage One
Screen universe for discount & NAV trends
Corp
Activity
(Event Driven)
Stage Two
Balance Sheet
Isolate dislocations and tactical opportunities
(Fundamentals & NAV Risk)
Stage Three
Rank on “cheapest”
beta & highest
risk-adjusted
potential
return
Discounts to Net Asset Value
(Absolute & Relative)
Expertise of the Fund Managers
(NAV Performance)
Stock Picking
(Bottom-Up)
Stock Selection
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Persistent Inefficiency and Differentiated Alpha
It is worth touching briefly on the key features of CEFs as an investment tool. These apply across all underlying asset classes, and are primarily:
•
•
•
•
Pricing inefficiency (discounts to net asset value)
Differentiated alpha source (discount volatility)
Access to best-in-class managers in a transparent, listed format
Fixed capital pools benefitting relative investment performance
The persistence of the “discount effect”, and its uncorrelated nature, is key to the investment proposition for CEFs.
We believe the core drivers of this phenomenon to be twofold, specifically 1) informational & behavioral arbitrage between institutional
and retail investors, and 2) liquidity arbitrage between listed CEF structures and their underlying assets. The following chart illustrates the
differing pressures and preferences brought to bear on the universe by the typical shareholder base.
Discount Insensitive Actors
Retail
Investors
Unitised
Investment
Trusts
Discount Sensitive Actors
• 401(k)
• Savings plans
• Sentiment driven
• Locked in capital
• “At market” creation and redemption
• Value-driven stockpickers
• Limited capacity
Sector
Specialist
Institutions
• Temporary allocations
• Value & activist bias
Hedge/
Value Funds
CEF
Universe
CEF
Sponsors
Wealth
Managers/RIA’s
• Dividend reinvestment
• Buybacks
• New stock issuance
• Usually yield-driven
• Client flows determine buy/sell activity
• Typically buy-hold
Investment Universe
The chart below summarizes the investment universe that can be accessed via closed-end funds listed around the world.
Fixed Income
(>450 funds, $148bn USD)
Distressed
Discounts
Equity
(>581 funds, $258bn USD)
Alternatives
(>177 funds, $133bn USD)
Mean
Reversion
Event-Driven
CITY OF LONDON
Investment Management Company Limited
Contacts
Information/Queries
U.S. Office
The Barn, 1125 Airport Road
Coatesville, PA 19320
United States
Phone: 610 380 2110
610 380 2116
Fax:
E-Mail: [email protected]
London Office
77 Gracechurch Street
London EC3V 0AS
United Kingdom
Phone: 011 44 20 7711 0771
011 44 20 7711 0772
Fax:
E-Mail: [email protected]
Singapore Office
20 Collyer Quay
10-04
Singapore 049319
Phone: 011 65 6236 9136
Fax:
011 65 6532 3997
Dubai Office
Unit 2, 2nd Floor
The Gate Village Building 1
Dubai International Financial Centre
P.O. Box 506695, Dubai, United Arab
Emirates
Phone: 011 971 4 423 1780
Fax:
011 971 4 437 0510
Website
www.citlon.co.uk
Important Notice
All reasonable care has been taken in the preparation of this
information. No responsibility can be accepted under any
circumstances for errors of fact or omission. Values may fall
as well as rise and you may not get back the amount invested.
The information contained in this document is confidential
and is intended only for the use of the person to whom it is
given and is not to be reproduced or redistributed. It is
intended for information purposes only and may only be
distributed to persons who are “accredited investors” and
“qualified purchasers” within the meaning of U.S. Securities
laws. This document does not constitute an offer to sell or
the solicitation of an offer to buy any securities, nor will any
sale of a security occur in any jurisdiction where such an
offer, solicitation or sale would be unlawful.