Few investment managers enjoy equity market downturns, for reasons ranging from capital losses to the palpable increase in client anxiety they create. Pullbacks force emotional interference, even on those investors who base decisions on clear technical benchmarks. The longer performance suffers, the more investors find themselves questioning their strategies.
But to dwell only on the negative aspects of a correction would be to overlook the abundance of opportunity it creates. These periods generally serve to amplify the attractive features of investments we already want to own and provide us with a window to purchase them at discounts.
Let's look at the closed-end fund universe. It consists of roughly 600 funds and has a total market cap of $180 billion, rendering it to a tiny corner of the overall U.S. securities market. This explains why the closed-end fund market tends to suffer more than its share of overall volatility during sustained market pullbacks. The same pattern repeats itself during almost every downturn-the lower levels of liquidity in the closed-end fund market leads investors to react more abruptly and impulsively than in other markets, often leaving many unpicked opportunities.
Developing the ability to pinpoint areas of the market where irrational investor behavior has pushed a security or sector into oversold territory can lead to substantial outperformance over the long term. Closed-end funds are particularly well-suited to provide investors with reliable indicators of their true intrinsic value in the form of a fund's price relationship to its net-asset value. If a fund trades below its historical average discount, you have identified the first step of many for successfully investing in closed-end funds.
It helps investors to have pre-established entry points where they would deploy cash before a pullback actually occurs, because as we witnessed on May 6, they can be short-lived events. Of course, it is impossible to know how every security will trade into a downturn and unforeseen opportunities can present themselves, but preparation should serve to narrow the scope of suitable investment options down to a manageable set. Employing the self discipline to buy is often the most difficult part.
In 2008 and early 2009, opportunities for deeply discounted closed-end funds were plentiful for both novice and professional investors. However, these easy money opportunities have passed and significantly more digging is required. As the market has recovered slightly, there remain some hidden gems. Royce Value Trust (RVT) and LMP Capital and Income (SCD) are examples of funds that have remained deeply discounted for superficial reasons, while many of their peers have narrowed significantly. These deeply discounted funds provide for significant upside potential and limited downside relative to the rest of the closed-end fund market, especially if you plan on having general equity market exposure.
We prefer to fold this approach for identifying undervalued securities in the closed-end fund market into an absolute return strategy that significantly limits downside risk for our high-net-worth and advisor clients. The premise lies in the neutralization of each fund's correlation to the equity market, so the portfolio captures the tightening of closed-end fund discounts. The intent of this strategy is to produce positive market returns regardless of equity market direction.
Buy low and sell high represents the basic principle behind every successful investment strategy. Market corrections present opportunities to accomplish this and harness previously inaccessible value as long as you have the self discipline to step in while others are fleeing.
Maury Fertig is co-founder and chief investment officer of Relative Value Partners, an independent RIA in Northbrook, Ill. For more information please visit www.rvpllc.com.