Retail buyers have a poor grasp of closed-end investment companies. That creates opportunities for Florida money man Erik Herzfeld.
By William Baldwin, Senior Contributor
Classical economics: All actors are rational. Stocks are efficiently priced.
Behavioral economics, per Nobelist Richard Thaler: Investors’ decisions are warped by emotion and ignorance. Prices can get out of line.
Count Erik M. Herzfeld, a money manager specializing in closed-end funds, in the Thaler camp. He aims to buy when fund shares trade at an irrationally low percentage of liquidating value and sell at a high percentage. Unlike mutual and exchange-traded funds, closed-ends don’t do redemptions, and their prices are a matter of investor whim.
“Big discounts and big premiums. It’s behavioral,” Herzfeld says. “No one reads prospectuses.” Or rather, he reads and retail investors don’t.
Exuberant buyers have (as of mid-September) pushed the price of Gabelli Utility Trust to a 120% premium over the value of the stocks it owns. Evidently they’re mesmerized by the five-cents-a-share monthly dividend, not understanding that, at an annual 20% of the fund’s net asset value, the payout is not sustainable. Nor have they fully absorbed how each dividend dollar they joyfully pocket has cost them $2.20, causing an instant $1.20 loss.
Herzfeld’s clients, who have entrusted $750 million to his Miami Beach firm, do not own that Gabelli fund. They do own shares of Central Securities Corporation, a wallflower that trades at a 19% discount to net assets. Exuberance for this fund died down soon after it opened its doors in 1929, a few weeks before the Great Crash.
If investors think Central Securities is a has-been, they are missing something. In 1982 the old fogies running it took a flyer on Plymouth Rock, a startup home and auto insurer, at $25 a share. Plymouth is now on Central’s balance sheet at $9,500 a share, but an appraisal of this privately held company puts its value, before a discount for lack of marketability, at more than double that.
Use the higher value for Plymouth and you see Central trading at a 36% discount. This fund, too, makes nice distributions, but in a mirror image of what’s going on at Gabelli, the payouts give rise to a windfall gain for fund holders.
How can cheap funds like Central coexist with absurdly overpriced ones like Gabelli Utility Trust? You’d think traders would arbitrage away the discrepancies. Herzfeld’s explanation is that Wall Street’s heavyweights find the closed-end universe, with but $224 billion in assets, too small to accommodate their bets.
The hedge funds you have heard about stay in the big-stakes wing of the casino, Herzfeld says. Recollecting his gambling diversions while getting a degree in financial engineering at MIT, he goes on: “I feel I am sitting at the small poker table. There are ten seats. Seven are retail. Three are professional investors. We make money on the retail guys because they are not good players.”
Herzfeld, 50, got a taste of Wall Street poker early in life. His father, Thomas J. Herzfeld, started tracking closed-ends half a century ago and opened Herzfeld Advisors in 1984. At 78, the elder Herzfeld remains chairman but pays more attention to his sailboat than to the share prices he once meticulously plotted with paper and pencil; the son is president and portfolio manager.
In 1990 Thaler and two other academics descended on the firm in quest of thousands of data points. In effect, they were trying to answer the question: Are closed-end investors crazy, or what? The resulting work, a seminal paper in behavioral economics, credits the teenage Erik for research assistance.
When Erik Herzfeld joined the family firm in 2007, after stints trading interest rate and foreign exchange derivatives at Lehman Brothers and JPMorgan, he vowed he could make money buying underpriced funds and shorting overpriced ones. His father, mindful of the adage that the market can stay irrational longer than you can stay solvent, decreed that Erik would be doing any short sales in his personal account. “Sure enough, I lost money,” Herzfeld says.
The clients are doing better with a long-only strategy. The firm claims a 6.2% average annual return since 2000 on its blended stock and bond accounts, net of fees (1% for large accounts), edging out a benchmark return of 6%.
The correction of 2022 widened discounts, making closed-ends look more tempting. But this is a treacherous field. Consider the many closed-end funds holding leveraged portfolios of municipal bonds. Now that overnight tax-exempt borrowings cost close to 6% while muni bonds yield 4% or 5%, the leverage is making shareholders poorer. Pimco NY Municipal Income III is no bargain, even at its recent 11% discount.
Why don’t fund operators end the pain by liquidating some of the bonds and paying off the loans? Perverse incentives. In many cases their fees are a percentage of gross assets, not net assets. If you want tax-exempt income, Herzfeld recommends you buy an unleveraged, low-cost exchange-traded muni fund from Vanguard or BlackRock.
One of Herzfeld’s more daring plays is the Cornerstone Strategic Value Fund. Its fat payout, 22% of net asset value, has caused it to trade at a premium, sometimes a very wide one. That premium allows the fund to offer shareholders a bargain of sorts: the right to buy additional shares at a reduced premium. In the last go-round, the offer hauled in $670 million from eager customers, and their newly delivered capital had the effect of raising the fund’s net assets per share. The NAV levitation in turn puffs up performance figures for the fund, driving the fund’s market price still higher. Herzfeld is playing a greater-fool strategy, aiming to buy when Cornerstone’s premium is at the low of its historical range and sell when it’s at the high end.
For conservative investors, there’s a simpler strategy. Buy closed-ends that trade at double-digit discounts and have either low expense ratios or large payouts. Two that show up on Herzfeld’s 13F filing are Adams Natural Resources and Neuberger Berman Next Generation Connectivity.
“There’s a lot of irrational exuberance,” Herzfeld says, alongside irrational pessimism. “That’s how I put food on the table for my kids.”
HOW TO PLAY IT
By William Baldwin
Closed-ends are buys when their discounts, combined with payouts, are enough to make up for their expenses. Such bargains are extremely scarce. One of them: BlackRock Science & Technology Term Trust, which trades at a 19% discount and dishes out a monthly distribution that comes to 9.2% of net assets annually. Multiply 19% by 9.2% and you see a 1.7% annual windfall. That more than makes up for the outlandish 1.3% expense ratio and the silly portfolio (tech stocks with covered calls written against them). A dividend cut would lessen the attraction, but not fatally, since the fund is planning to liquidate in 2031.
William Baldwin is Forbes’ Investment Strategies columnist.
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