TFS Closed End Fund Strategy

The strategy seeks to create portfolios of Closed End Funds (CEF’s) which provide a high level of current income with the potential for capital appreciation.The strategy will invest in CEF’s which are trading at significant discounts to Net Asset Value (NAV) and provide high levels of current income. These portfolios will primarily invest in the following CEF’s sectors: Emerging Market, High Yield, and Energy/Resources. MLP’s and REIT’s may also be used.

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Closed End funds have similarities to exchange?traded funds. They are launched through an initial public offering. The proceeds of the offering are invested by the fund manager according to the fund’s strategy. The CEF is then configured into an equity security which trades on an exchange in the secondary market. Investor activity takes place in the secondary market and has no impact on the underlying assets or NAV of the fund. An ETF, on the other hand, has a market maker which can either create more shares or redeem shares to keep the value of the ETF close to its NAV. A CEF does not have this mechanism. This leads to periods when the market price of the CEF may differ substantially from the NAV. This tends to occur during periods of extreme volatility and investor sentiment in the marketplace. CEF’s are frequently leveraged into “little income producing factories”. This leverage typically may be 25%?35% of the assets of the fund.

Gold_InvestmentThe CEF is a relatively complex investment vehicle which makes it less liquid and more volatile than ETF’s or mutual funds. The dealer community does not normally follow CEF’s and the market is too small for institutional investors. This makes CEF’s a retail product which is followed by a relatively small group of sophisticated investors. This frequently creates opportunities during periods of extreme negative market sentiment when investors are desperate to liquidate their holdings.

We monitor the CEF universe for funds with high levels of current income which are trading at deep discounts to their NAV using a measure called the z?statistic to determine the relative attractiveness of the discount. When the Z?stat is ?2 it means the funds discount is 2 standard deviations from its average. We like to look at this measure for differing time periods such as 1, 3, 5, and 10 years. When this measure is ?2 or less it is considered statistically “undervalued.” This is not a common occurrence, but does happen during market extremes. After we determine a fund meets these criteria we then take into consideration the following in our bottom up analysis: Morningstar ratings and reports, the people involved in the management of the fund, the process the fund manager employs, the positioning of the fund, the risk & return characteristics of the fund, fees, and leverage. We employ top down analysis to determine which category and style to emphasize. For example, we may choose to overweight emerging market fixed income because we feel they are attractive and will outperform high yield funds. Diversification among funds is not a primary concern.

The best use of the strategy is to build up the income component of the portfolio while waiting until the CEF’s return to more normal pricing. The best time to invest in CEF’s is when market sentiment has been very negative and these funds are trading at deep discounts to NAV. Since this only happens occasionally, it is difficult for money managers to develop an ongoing stand?alone CEF strategy. We believe the best use of CEF’s is to augment existing portfolios with CEF’s when opportunities present themselves.