The Case For Closed-End Funds, With John Cole Scott

Closed-end funds and similar products offer a compelling opportunity for High Net Worth investors, but many investors do not understand these products, or how they can fit into an overall portfolio strategy.

John Cole Scott, president at Closed-End Fund Advisors, joins Andy Hagans to discuss how he helps clients generate alpha with closed-end funds, BDCs, and interval funds.

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Episode Highlights

Background on John’s career, and how he was “apprenticed” into the closed-end fund and wealth management space.
Why closed-end funds offer the opportunity for alpha for enterprising investors and advisors.
The differences between BDCs and closed-end funds, and which product wrapper has the most momentum in the market right now.
John’s thoughts on whether interval funds and similar intermittent liquidity products should be thought of as primarily liquid, or primarily illiquid.
John’s predictions on where the industry may go in the next three to five years.

Featured On This Episode

AICA – Official Website (AICAlliance.org )

Today’s Guest: John Cole Scott, Closed-End Fund Advisors

About The Alternative Investment Podcast

The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.

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Show Transcript

Andy: Welcome to “The Alternative Investment Podcast.” I’m Andy Hagans, and today, we’re talking about closed-end funds, BDCs interval funds, and all kinds of exciting product structures, and a very unique strategy that my friend, John Cole Scott, uses to generate alpha for his clients. John, welcome to the show.

John: It’s great to be here.

Andy: It’s not a warning, it’s more… I want to tell my listeners, John, is his knowledge, because I had a prep call with you, John, you used the phrase “drinking from a fire hose,” and it is, like, in a good way. And so I wanna soak up as much as I can with this episode. I want our audience to soak up as much as we can about closed-end funds, BDCs, interval funds. But before we get into all that exciting stuff, because I know you have some very unique strategies, I am wondering how you got your start. Could you share with us how you got into finance or even into this little, could we call it a niche in the world of finance?

John: It is. So, I mean, I’m an undergrad psychology major from the College of William & Mary in Virginia. And my father happened to go to university with a guy that also invested his lawn mowing money in the ’50s in the stock market. And they thought the Beta House in Walla Walla, Washington was too rowdy. So they got an apartment together. Fast forward about 10 years, Eric Bergstrom has picked up some resources working at the American Express Funds back in the ’60s and the bear market of the ’70s. Oh, and my father got married after being a coast guard and a journalist in London. And he needed to have a regular job for a family.

So he became a financial advisor. His grandfather had been a financial advisor in Richmond, a fifth generation back to the 1860s here in Richmond. And so there’s the bear market of the ’70s. I don’t think either of us were alive for that. You know, the bear market part, I don’t know your age exactly, but it was tough. And a closed-end fund is not a new investment. They actually go back to 1893 in the New York Stock Exchange. So they’re definitely durable and been around for a while. But there was a venture equity closed-end fund publicly traded called Dibo Capital, and it listed and then the stock market blew up.

So let’s say the NAV was $10, it fell to under $5. And then because closed-end funds had this really interesting relationship, the Net Asset Value, just like the other funds you’re probably used to, is typically reported daily. But the market price, the way you buy or sell, the liquidity component, isn’t at the fund sponsor level, it’s actually the free market. Like you buy any ETF, any stock, anything that’s publicly listed, it can dislocate on the downside and dislocate on the upside. And so basically, it went to roughly a 50 discount. So imagine for under $2 and mid-change, you can buy a $10 recent IPO, and Eric had enough money, he bought over a third of the stock.

My father, family friends bought another 10% or so and he became a board member of this closed-end fund that he just was starting to learn about. I’m gonna fast forward a long way, go to the ’87 crash, and he had focused more on these funds. He had started, you know, worked in the space, added more of them to his client portfolios, but it was maybe half of what he did. You know, he still would do other things in the market as it made sense for his clients as a registered wrapper stockbroker. But when that crash happened, he decided, “You know what, I’m a writer. I want to highlight this thing that I know more than other people.”

So he started a newsletter called “The Scott Letter Closing Fund Report.” And I do remember as a young child licking envelopes for slave labor to help start that business. And it never probably made a profit, but what it did is it gave him an audience and it gave him recognition for doing good work as a journalist and an investment manager even way back when. So then in 1991, when my father was 54 years old, he co-authored a book on closed-end funds with a finance professor that was a durable college-level book. Again, I read it in high school, and it was my dad’s version of having me drink from a fire host, you know, as a 17-year-old.

And then soon after, there was this REA firm in Santa Barbara, California, and it basically imploded. And he was known enough that the owner that survived asked him to come in as a minority shareholder, become a portfolio manager, do day-to-day. And then within a few years, we had brought it from Santa Barbara to Richmond, Virginia, where we’re raised and born from, and then bought all the stock from him. And this all happened when I was in university and, you know, I actually went out to California, helped him with the company because I’m organized, I was more organized than he was. And had a great time spending time with him.

And then I graduated William & Mary and I just knew I liked people, I knew I liked interesting things, and my dad needed help. And he goes, “Can you gimme help at the firm?” And so I basically joined him until I found a better job. And I’ll tell you, unless you’re hiring for something really amazing, I’m probably not gonna get a better job. So it’s a really interesting… I didn’t plan to work with him. And then I’ve grown the business in my 22 years, we added BDCs coverage in ’14, you know, we built a data business, so we aren’t just an asset manager like many advisors, that’s our core business, the reason we wake up every day. But we said, you know, these other larger data providers that I probably don’t have to name, make a lot of reoccurring mistakes. I can catch mistakes.

I care about mistakes because I trade for clients and I like to build a quality thing. And I’m not only interested in purely profits, you have to be profitable as a business, but as a smaller business where you don’t have shareholders, don’t have a board, don’t have bondholders, you know, we’re family-owned, we have no debt, we have no one who can say no to us. We’ve built a great durable data business. And now with the advancement of interval funds and non-listed BDCs, the universe is over 700 funds and over $700 billion in assets. And that’s smaller than ETFs.

Andy: That’s smaller, but, you know, John, so this is… I mean, I got a couple of thoughts right inside my head. Well, one is kind of interesting that, you know, the way you grew up and got into closed-end funds, it almost makes me think of like the middle ages, and your dad’s a blacksmith and so, you know… And so you apprenticed to him. I’m like, it’s such a… I don’t wanna say it’s an odd little niche, but I actually love these things in finance. There’s all these little nooks and crannies and, you know, you talk to traders who literally will just trade one product, just one product, and, you know, they might make a fortune off the one product. And I honestly think in finance and investing, we need that.

Like, we need people who know every nook and cranny of a particular product type or a particular market or else… You know, especially in public market. Like, we need transparency. Like, we need people who understand the mainstream data that we’re getting about this product type, you know, that everyone is looking at actually has issues, you know? So I just kind of appreciate that. And like you said, it’s not the size of the ETF market. On the other hand, do you think that the fact that it’s a little smaller, I mean, to me, that can almost be a good thing because if it was a bigger market, you’d have a harder time being a small business and kind of, you know, cornering that market.

John: It is. You know, I kind of say, you know, because now we are four W2 employees. We’ve grown to be three programmers and seven analysts on our data team and have tremendous vendors as any good small business can have to fill in the gap. Great law firm, great accounting firm, whatnot. And so maybe I could add two more people and probably be as big as I need to be in my business. And we do a very good job. And I can go speak of a CFA society or a CFP society or individual investors at the AAI Chapters, you know, and I’ve been paid, again, not a lot, but the travel just to get me out there to just speak because there’s no local resource.

And at the end of the day, with my undergrad in psychology, working with children and teaching them motor boating skills in my other job, I hope that I can try to break down the complexity into digestible bites. I’ve gotten much better as my hair’s gotten grayer. And then I’ve also really tried to learn that through the bumps and bruises of capital markets, because they always are gonna happen, but you never see it coming. And I am always in love with my psychology background, we go, “What’s a normal year in the market?” There’s never actually a normal year. There’s just years where you made money and years where you lost money.

Andy: Yeah, there’s even decades, you know, like having Meb Faber on the show talking about taking that really zoomed-out view. There’s even decades that are very dissimilar or multiple decades, you know, so I think people kind of, were too anchored to the idea of the norm. But, you know, one thing that I’m curious about, so you have this, you have the data side of your business and then you’re also an advisor, and you have the advisory firm. Are your clients coming to you because they’re already sold on the idea of closed-end funds and, you know, having them in their portfolio? Or are they coming to you just because of your general reputation and then you sort of educate them on the benefits of closed-end funds?

John: So, I have a peer firm where it’s much more the latter where basically they happen to be a quant manager in closed-end funds, but like, did they meet their friends through synagogue and neighborhoods and just chatting with people because they’re friendly, intelligent folks. When we bought the firm, we moved 3000 miles. I recognized my dad’s book and the newsletter. We could have rebranded the firm, you know, Scott and Scott, or, you know, put our names on it. You know, like let’s keep a name. It’s obviously older and it’s not tied to one human. You can always add partners and grow over time. So most people now find us… I’ve always, because my father’s time in the press, really tried to partner a perspective in educating with data and comments for the press, helping those sources. I’m a small business. We don’t have the large marketing budgets of large asset managers with wholesalers and deep resources.

So I’ve learned to focus on help the press, and they usually get it right and people Google the word closed-end fund, the organic search traffic alone. And this is a fun time to say our main website is cefadvisors.com. It’s about to turn 20 years old. It is horrible. But you don’t have the best website if generally older people are finding you and just pick up the phone and call you. Like, this phone will ring and a retired dentist or engineer from California, or New Jersey, or Florida will give me a call, he goes, “Yeah, so either I own a lot of funds I’m gonna do it yourself-er, and I’m trying to decide when I get too old and, you know, looking to not have me on the line. I wanna go see my grandkids every weekend.” Like many closed-end investors spend the weekend catching up on their work.

And so I’d say that’s much more as we are more of a national brand. We’re not a huge…you know, we’re a little under $200 million in assets. We’ve raised about $500 million in a UIT fund of BDCs. That’s been the last eight or nine years. You know, 65% of revenue is still, you know, fee-based. That’s the core of our firm. But the data research, you know, people spend thousands of dollars a year for a daily spreadsheet, a weekly or a monthly because we already need a collective to do our job. We just, you know… I tell people we found a way and telling them that other people pay for the tool I need the most.

Andy: For your main business. Well, it’s interesting, talking about, you know, a 20-year-old website. Actually, I love that. I think there’s a lesson there, really, with entrepreneurship and branding. I don’t know where the phrase came from, but, you know, “The riches is in the niches.” Just as a strategy, if you can stick to one thing and, you know, I don’t wanna say doggedly, but consistently, and, you know, at a certain point you become associated, you know, with that one thing.

So, I think there’s definitely something to that. And, you know, it’s interesting, with alternatives like this show covers alternatives, there’s so many different kinds of alternative investments. The whole industry right now is undergoing tremendous growth, tremendous inflows of assets, really has been for the last decade or more. But I feel like some of these products are kind of in the next generation version of, you know, next generation of BDCs, next generation of interval funds, next generation of certain types of REITs. And so it’s kind of cool to see, you know, probably what was some people’s vision 20, 30 years ago. And I feel like it’s finally here. Do you have that sense?

John: I do. I mean, remember I said that one key feature of a closed-end fund is that disconnected market price? The listed fund, which is the most well-known. And the asset value, the ebb and flow, it’s not perfect. It’s erratic. You know, there’s fear and greed like any of that…

Andy: That’s great. John, I love that stuff. I mean, those are the nooks and crannies where you can generate alpha, right? Inefficient market.

John: It is. The other thing is, because of that, there’s no daily inflow or outflow of capital like an ETF or open-end fund. So even though this wasn’t the design in ’19, you know, the oldest fund is a 1927 relatively boring U.S. stock fund. It’s basically like an active S&P 500 fund in a lot of ways. But it’s a closed-end fund. It trades, but see, it was pre-1929 crash. But the really useful thing is that fixed capital structure means that, like last week, you know, there’s a close-end fund of regional bank stocks and its manager didn’t have to sell a single stock. He probably rotated, I don’t know yet. Because he didn’t have to, he could rotate between…you know, maybe he sold JP Morgan and bought First Republic, and we’ll see what happens. But an open-end fund or ETF generally in those environments, there’s a net seller. It’s a similar structure, but a different…

Andy: Like you’re talking about forced selling just because of inflows and outflows.

John: Andy, let’s say you have $25,000 in the open-end fund version of that regional bank stock. You might go, “I’m scared, I’m gonna pause. I want my 25,000 back.” The funds sponsor accepts your shares and spits you out cash. The closed-end fund manager just manages the money. And then if you wanna sell, you go find a buyer in the market. If you wanna buy, you go find a seller in the market, just like you buy regular listed possessions.

The other really interesting thing is they, in their capital structure rules, they’re able to have leverage. So a preferred stock. Not many used preferred anymore, but the original leverage was a preferred stock like exactly the way banks lever themselves. And they do that to add more assets to put in the market, which means they’ve evolved in the U.S. mostly for income. There are non-income strategies, but even the funds that really look more growth-focused will typically pay a quarterly dividend, sometimes monthly just because investors learn to really appreciate that inflow of cash into their portfolio when they’re building an income portfolio.

Andy: So is that, you know, at a really high level, closed-end funds and maybe to an extent, BDCs and interval funds, maybe they’re the same, maybe they’re different, you tell me. But what’s the appeal to an investor? I know you live and breathe closed-end funds. I mean that is a compliment, but let’s just say, you know, I’m a typical Joe Schmo, Jane Schmo investor. I have a 60/40, I’m interested in diversifying, at a very high level, why closed-end funds? Why should I be including these in my portfolios?

John: So, first off, I’ll say because we find they trade fine for us and there’s even billion-dollar firms that don’t have problems trading. But if you are a multi-billion-dollar firm, and you’re looking at closed-end funds, there’s very few that you’re comfortable with the average daily trade volume because it just looks very light. So automatically, the general user base are portfolios under $100 million. Honestly, for institutional investors, $25 to $75 million is the most tactical book we see with our data clients in our contacts where when things are boring and there’s many other exciting things, whether it’s SPACs or currency or crypto, they’ll just have a small little portfolio then they will triple it through periods like last year or maybe even last week because, you know, I can sell an ETF and there’s a closing fund that’s kind of similar, maybe even the same manager, and this discount has gone from an 8 to a 14… I’m making these numbers up, right? And now I can rotate from a similar NAV to a wider discount.

Andy: Oh, interesting. So you’re telling me, you know, the… I think I get it. Maybe this is obvious. Okay, talk to me like I’m five, and let’s pretend I’m smarter than a 5-year-old. But the underlying securities then, let’s say in a regional bank ETF or a regional bank closed-end fund, the underlying securities would both be down by the same amount, but then the closed-end fund would have an additional possible discount on a bearish sentiment-type day. So just even as a purely tactical or rotational strategy, there will be institutional players who will have a little bit of an allocation to closed-end funds that they can scale up or down, depending on market conditions.

John: Absolutely. And again, there’s only like one regional bank stock I’m only using because we’re recording. The banks are failing. Much more common are, like, credit risk-focused funds. So high-yield, multi-sector, CLO, senior loan, and then BDCs are a modification of the ’40 Act of 1980, but gained traction after the great financial crisis, they’re basically $25 million or less loans to small U.S. businesses. And it allows you, you can take $5,000 or $500,000 and buy X shares of that BDC, and it’s in your portfolio, and you’ve got liquid exposure to quarterly marked private loans. And those things generally yield, you know, 8% to 10%, both last year’s pullback, the increase in yield there because their assets are like variable. They’re like…

Andy: So BDC, you could almost think of it like a junk bond-type risk income, but it’s not a junk-rated giant corporation. It’s just a mid-size business or whatever.

John: Most of them have at least a half billion dollars of assets. Very few have over $10 billion, but there’s a few with $20 or $30. I mean, there’s a large, like GSO Blackstone, large credit manager, Aries Management, large credit manager, they’re the two largest on the listed and the non-listed side. And so you have that exposure. But the difference is like 90% of the loans are typically variable for 90%-plus of those BDCs. So they’re much more like a corporate loan. So imagine, in the last…

Andy: Oh, so there’s no interest rate risk really then, it’s default risk.

John: Very little. And then they have very… Going into everything, they were smarter than an average, you know, kindergarten or 5-year-old. They had a lot of fixed leverage in variable assets. And so our index did 11% dividend growth rate on a one-year basis looking back in time.

Andy: So, if you owned BDCs last year maybe as a rough replacement for some of your other fixed income, you were sitting pretty while everyone else was catching a bunch of falling knives and you were saying, “Thank goodness I invest with John Cole Scott and he has me in all these BDCs.” Is that basically…

John: It is. Small caveat, there’s about 30 liquid BDCs and the homogeny there is nonexistent. There are good BDCs that have good portfolios, good fee structures, good corporate governance to their stockholders. There are BDCs that are sometimes good at credit, but bad at fee, bad at their corporate governance. And so there’s a very different outcome. Last year, BDCs were down 10% total return. But to say that they yield 10%, they were still down 20%. This is where our client base is potentially different than some of the advisors we talk to. When people give us their money, we use our data, we use our experience, we use our brains to build an asset allocation, and then we decide which structures make sense, and then we pick the spots, but then we focus on income in a risk or tax-optimized outflow.

And then our database can produce reports that prove and project. So we don’t like being down, nobody does. Our diversified strategies were down 11% to 13% last year, total return after fees. I mean, we have 16 different types of investments. Again, definitely, my liberal arts schooling comes through in how I run our firm. We have a lot of different ideas, but we just like to build what people need. And some investors are 50 that hire us, some 90. Some investors are a qualified account, some are taxable, some are in a tiny tax bracket somewhere in the God love and high.

Andy: Yeah, you can’t. I wouldn’t think you’d have one portfolio model that applies to everyone. Everyone has different goals, time horizon. Some people need, you know, more income. Well, one other question about these BDCs, you know, zooming out, you know, I guess… Again, I wasn’t really around or I wasn’t covering the industry, but I feel like BDCs had a pretty bad reputation, or at least a mixed reputation, shall we say. But, you know, like I said, the next generation of them seems like there’s a lot of excitement around a lot of the newer products. But why are there still poorly run, poorly governed, high-fee BDCs? Like, what is it about the marketplace that’s allowing them to raise capital? Is it just the…

John: So, a couple of things. Because they’re yield-focused, their shareholder base tends to be on platforms like Seeking Alpha, where very intelligent people can write about BDCs and your pet monkey can write about BDCs, and then insert other investment there. Another thing is, back in 2014, there’s a ruling for indices that have funds in them that were BDC funds, because BDCs are closed-ended management companies, they’re ’40 Act funds. They just look a little different. They act a little hairier than a regular mini-bond closing fund. But if there’s a 2% expense ratio, and that’s not the answer, it has to be weighted in the acquired funds fee.

And that might confuse most retail, but it meant the fat card for an ETF that included BDCs had a higher expense ratio. And just for giggles, I went to the exchange conference last February in Miami for ETFs because I have friends down there. It was warm, and, you know, I can always learn something. And it’s so interesting that ETFs, in my experience, seem to only be sold on, you know, like tracking error, expense ratio, you know, versus closed-end funds tend to be sold how wide is the discount, how high is the yield, how good is the manager? And so those removed a lot of institutional investors from BDCs. And so that means there’s less smarter people voting their 13 filings versus the way that larger institutions can say, you’re a good manager, you’re a bad manager, improve this or this. There’s a few activists in this…

Andy: So you’re basically saying there’s retail investors, they’re looking for income, and maybe I’m on Seeking Alpha or Twitter or whatever, who knows, and on paper, this BDC looks great because the yield is this or that, but the fees are very high. Whereas in ETFs, if you don’t, you know… And I covered the ETF space many years ago, and I mean, I think it was the case even then when we started ETF database and we were building out our database covering that world, even then, if you didn’t have a competitive product, you didn’t survive, you know? I mean, maybe the first 50 out of the gate that had, you know, the good ticker names, etc., but really, even in the second wave, and we’re probably in the fourth or fifth wave of ETFs now, but even in that second wave, if you did not have a very competitive expense ratio, and good index and, you know, pretty good liquidity, you were just gonna get squeezed out of the market by Vanguard, by Schwab, you know, by these bigger players. So sounds like there’s not that kind of a market dynamic in the BDC industry.

John: It is. And at the end of the day, I mean, a lot of people are attracted to yield. And we always try to use the phrase dividends at a closed-end fund and a BDC are policies set by a board of directors, but then the portfolio managers team have to execute towards. And then some funds move their dividend policies all over the place, some keep it the same, even if they’re eroding capital and giving you back your own money, in my opinion, they just hold it the same. And, unfortunately, imagine two credit managers, one goes, “Okay, our leverage is this, our earnings are this, let’s move this up one cent, let’s move this down two cents. Let’s ride the waves of the movement of net investment income from our investments and the costs from our liabilities.” Just like if you’re in a household and suddenly your gas prices go down, you can spend more somewhere else or save more.

And if like your restaurant prices go up, I mean, you’ve gotta balance things out over time. And what’s interesting, the funds that do that sometimes trade worse because people see change, and nobody likes change. And there’s a couple of funds, and I maybe won’t go to funds on this podcast, but that have never changed their dividend policy. And people say, “Thank goodness for this fund, they’ve never changed it.” And I go, yes, but what’d you pay for it? What’s it worth now?” And…

Andy: John, I feel like you’re almost telling me that investors in BDCs tend to be dumb.

John: Well, I would say… So, on average, they are more likely to have a college degree and have more money. But as you know, that doesn’t mean you’re not smart at investments because…

Andy: We’re all humans, we’re all psychological, emotional.

John: A lot of emotion in investments.

Andy: Yeah, I do. You’re preaching to the choir, John. I mean, you know, I work with private equity funds and I work with sponsors and I try and always scream from the rooftops, you know, underwriting’s important, IRR is important, all this stuff is important. But human beings, investors, even at the institutional level, even at the RIA level, we all have emotions, we all have psychology, and we don’t make decisions based on rational logic 99 times out of 100. It’s not that those things aren’t important. Proforma, risk, underwriting, all that’s important, but, at the end of the day, that’s really not what sells funds. It’s not what sells securities. Usually, it’s a story, you know, or what you’re talking about with, you know, a story of a consistent dividend. It’s simple, and, you know, people will latch on to something like that. Right?

John: And I was talking more about closed-end funds there than BDCs, but it’s about 50 listed BDCs, about 450 listed closed-end funds. It’s about a 500-universe world, and there’s always much, but there are funds that I expect until my dying days will never cut that dividend. Like, they will take the ship down because they don’t know what to do if they’ve done it.

Andy: Well, that’s their brand. I mean, if that’s your brand and that’s what everybody knows you for, then it’s almost like, you know, I see the logic that you would fall on that sword, go down with the ship.

John: And so hopefully a simpler concept for your listeners that are dabbling in closed-end funds, I would say definitely, you know, the dividend policy is a policy, not that promise that you bought a bond, it has to pay you a coupon every six months or bank wraps. And that premiums aren’t always bad. But if you have an overpaying dividend tied to a premium and then the market shakes or the board finally changes the math, you tend to have an outsized downside reaction. Because if a bond fund at a 10 discount cuts its dividend 15% and a bond fund at a 10 premium cuts dividend in 15%, can you guess which one goes down more in magnitude the next day? And you don’t even trade closed-end funds. You could probably get…

Andy: Yeah. So okay, you know, these are fairly…what’s the word I’m looking for? Esoteric. I mean, for everyday investor these are a little bit more comp… There’s a little bit more to wrap my head around. I think, you know, what I’m hearing these products, you know, closed-end funds, BDCs and, you know, maybe depending on the type of interval fund, they offer quite a bit of yield or income usually, you know, again, depending on the fund. But then there’s also, because of the idiosyncrasies or the nooks and crannies of the market, opportunities for, you know, inefficiencies, and therefore, opportunities to generate alpha

John: And to be a contrarian because, so imagine if like… So last year, energy was kicking butt, you know, but the year before, it wasn’t. So there are fatter discounts and beat-up NAVs. And then last year, retail assets had a bad year. And so the Munis, because duration risk is real. And I don’t know this year’s outcome, but we are overweight Munis as it makes sense for the client’s income, risk, personality and overweight real assets because we love to be a contrarian because we don’t daily-trade. We can trade daily, but we’re not daily-trading for any one client. We’re not…

Andy: So, John, you’re a value shopper, it sounds like to me, like, so REITs, publicly-listed REITs right now or publicly-traded REITs, they’re often trading at a pretty big discount compared to…

John: Real estate closed-end funds. So, I mean, REITs are… And so there’s about 15 REIT real asset closed-end funds in the listed market, and then we love the liquidity of the listed market. And some funds can have 5%, 10%, 15%, 20% private exposure, which you cannot do over 15% in an open-end fund. And sometimes you really want to be in those private companies because so many companies are not becoming public or going public later. You’re missing out on so much of that trajectory. But the challenge is because most investors dislike too much private, if there’s too much private, they give it a discount penalty for not knowing what the private markets are of that portfolio. However, there’s newer funds, not new, 1989, but newer growth have been in interval funds where you actually, it looks and feels like an open-end fund, you can inflow daily, it can be 80% private equity private debt and they only offer typically 5% of liquidity a quarter and the board could vote for two or more percent if they wanted to. And that’s a great way to get large outsides illiquid investments in a way you can monitor it regularly and not those normal lock-ins, you can do $5,000 for most funds. So it’s not a private fund, it’s not a…

Andy: Oh, okay. You know, I wanted to ask about interval funds. And I had another guest on recently, we were talking about BREIT, and so some of these products, whether interval funds or intermittent liquidity products as you mentioned that 5% redemption limit quarterly or whatever that limit, maybe a monthly limit, redemption limit, or quarterly, or both. You know, I don’t wanna say my objection, more my question is how are they being sold to the retail investor? What is the retail investor’s understanding of them? Do they truly understand intermittent liquidity? You know, I think in the human mind, you can kind of round that up to saying, “Oh, it’s liquid, but you’re forgetting about the intermittent.”

And then now, I’ll use a phrase, are these things half pregnant? It’s like either you’re liquid or you’re illiquid. If you’re intermittently liquid, then I would say, well, that’s not really liquid because really, when does the liquidity matter? It matters in a bear market or it matters in times of volatility when things are going bad. And so if the liquidity disappears or is very limited when you need it most, then to me, it’s like, okay, maybe semi-liquid or, you know, or just it is human. And again, I have no problem with issuing these types of funds as long as it’s communicated what they are and how they work. So, to me, that’s really the challenge, do the retail investors understand what happens in times of market turmoil to these products?

John: So a couple of things. It took us years to actually even consider interval funds. And then really what happens, we started seeing managers that we liked their other funds, their listed funds, like PIMCO, which is a well-known asset manager in the closed-end fund space with taxable credit and permissible brought out PFLEX and suddenly most of their closed-end funds were at premiums. So you’re paying $1.10 per net. So now the question… And the expense ratios are essentially the same. Asset allocation’s a little different and leverage is a little bit less, but they’re very much, you know, sisters, not cousins or neighbors. And so if you could say I could take $1.10 to buy $1 of a publicly liquid investment where $1.10 could become 90 cents in a down market, you know, no guarantees.

Or I could spend $1 on a fund where it’s gonna stay $1 and move what the actual portfolios work. But I have to be willing to worry about the liquidity. So this is how we address it. Some clients, we talk about interval funds and what they are and we can drop your volatility with downside discount volatility by having overweight interval funds. Overweight to us is 15% to 25% because I don’t think any investors should be all illiquid anything because everyone has unexpected things in their life. We manage money for retired investors, not 400-year-old endowments that’ll be here 400 years from now. You know, we don’t manage money in that mindset.

And we also tend to put just 2% to 3% in a fund versus for listed funds, it tends to be, you know, 2.5%, 3% to 5%, maybe 6%. If you ever see me doing 6% in a fund, it is a sweet spot home run. Manager, discount, sector. It’s perfect almost. Doesn’t happen very often. That’s how we deal with it. And then when discounts got narrow pre-COVID, we were a little bit overweight interval funds because discounts were only 2% on average when they normally average 8%. And then what happened is since COVID, it’s been slower, we’ve actually reduced interval funds to buy more deeply discounted closed-end funds. But that…

Andy: So, for you, I mean, you’re looking for pockets of value, and it sounds to me like, you know, you specialize in these closed-end funds, the BDCs, the interval funds. You’re a little bit agnostic or willing to go into different wrappers, depending on the current market conditions.

John: It is. Or the client. And so when a wholesaler calls me and I go, “Give me your…” We have a database, I pull them up in my database, I look through expenses, I look through performance, I look through their holdings, I go, “Is the wrapper and the illiquidity worth the squeeze? Is this something where…” Because, you know…

Andy: Well, so let me ask you about that though. You just said, is it worth the squeeze? So do you treat an interval fund as essentially an illiquid product?

John: I do. I think…

Andy: So, that’s why that’s… You see, John, we’re of the same mind then. Because I’m saying you can’t be…

John: …if you need the money within three years.

Andy: Yup. So, then you can’t be half pregnant. The interval fund is pregnant. And that’s my concern, is not your firm, not you, but, you know, like investors in BREIT, it seems like, boy, is there a stampede for the exits right now, you know, I kind of wonder what was their expectation investing in that, you know?

John: And so they also have a BCRED that’s a non-listed BDC. It’s actually the largest BDC by total assets in our database, and we license data to them for their use. So I know that pretty well. And the guy that buys myself also does BCRED… BREIT, sorry. So we know about it. And then I’m treasurer of two 501(c)(3)s, one is my William & Mary Alumni Association. We have outside assets and one of its investments recommended by the investment managements firm we hired, but I obviously review that is BREIT, and it was up 8% last year. But again, our portfolio is not a retired income portfolio. It’s an endowment for…

Andy: It’s an endowment, yeah.

John: …the third largest, quasi-endowment legally, but the third largest alumni association in this country for an entity that’s 330 years old.

Andy: So when you’re buying BREIT in the portfolio like that, you can treat it as an illiquid investment. Like you don’t actually need the liquidity for an endowment or you might need a little bit.

John: Yeah. And again, that portfolio is like a $12 million portfolio and we put I think 3% or 3.5% in it. And we put 3% or 3.5% in an open-end fund because that’s what we use with that platform of, you know, an open-end fund of listed real assets.

Andy: Yeah. I mean, and again, this is [crosstalk 00:37:07.660]. It’s not really about product design, it’s more about the distribution. That’s my question with these products, is that last mile of the retail investor, are they understanding, you know, if you’re better off thinking of it and like you think of it, that it’s just primarily illiquid, that may give me some liquidity, you know, sometimes, but…

John: I mean, more liquidity than the private, like a hedge fund, you know, 10-year-fund. And again, part of being the treasurer of two 501(c)(3)s, part of selling data to my peers and talking to fund sponsors… And I can’t talk to everyone. I’m only one human, but I talk to a lot of people, not as many as you, Andy, because that’s your job, but a lot of people. I set up a 501(c)(7) trade association in 2019 to bring the industry together.

We have a weekly podcast, that’s actually, I think, how we met, was chatting about podcasts, and we do events and we try to bring investors, and advisors, and platforms and create a unified place to create content. And I say, don’t shoot yourself in the foot. And I talk to Morgan Stanley about how they should think about interval funds and I go, you know, and they do require every financial advisor there to sign off and every client is aware of the reduced liquidity of that fund. I’ll bet you, there’s some firms out there that aren’t requiring their investment advisors to claim that.

Andy: Okay. So this is on, you’re telling me even in this organization that you’ve set up, this is already, what I call the last mile. It’s already on the radar of a lot of these larger organizations. It’s obviously on your radar.

John: It is, and like now we can see a TD Ameritrade becoming Schwab and I push…again, I’m not there to be his client, but I’m like, you know, when a client sees a brokerage statement, this interval fund in a mutual fund labeling system, just like closed-end funds are in common stocks and they’re not a common stock, there’s common stock of a fund that’s gonna be nerdy about it. I go, “Can you please just take 10 minutes and put interval fund for these ticker symbols, you know, buy a database, buy my database, buy somebody else’s database. I’ll study the data if you want, but just get it,” and that way an investor goes, “Oh, these are my interval funds, these are my ETFs, these are my common stocks, these are my closed-end funds.” Just properly labeling things to me will help a lot. And then advisors and investors won’t be, you know, misunderstanding what they could have access to in their taxable accounts in their qualified accounts.

Andy: No, totally. It’s so interesting that there is so much value in getting the basics right. And it’s like this is true for mom-and-pop retail investor all the way up to ultra-high-net-worth family offices who like are doing transactions where they should be completing a 1031 exchange, but they’re not, you know, it’s like just, “Guys, let’s just get the basics right.” Probably two-thirds of the alpha you can generate is like low-hanging fruit, you know, just basic tax planning, really basic best practices like what you’re talking about. So, I know we’re almost short on time here, John, but I want to ask, you know, you cover closed-end funds, you cover BDCs, you cover interval funds, where do you see the most growth coming from in the next three to five years, you know, within those wrappers? Does one of those segments really have the most momentum behind it right now?

John: So the listed fund market was doing great till a couple of very large funds had very… Again, they were great ideas in ’21, they were horrible ideas in ’22. That market tends to take longer time to come to market. It’s usually large IPOs and about a month of raising capital. The interval fund market was really growing the fastest. Nice regular increases in the funds. Some funds always die every year. That’s nature of an economy or a market.

Andy: Sure.

John: The biggest increase right now are non-listed BDCs. And people doing, you know, things that kind of mimic that in a way. Now, I don’t know the future. I think that the non-listed BDC structure are a beautiful structure, you know, Blackstone has one, Nuveen, Churchill, TIAA-Cref, whatever they’re called now, has one. And lots of people have them and, you know, they’re useful as long as you understand what’s the fee costs, what am I getting, are they good at credit? Am I getting up the middle market, lower? Is it more variables? You know, there’s mixes and different pieces in that neighborhood. I still think the interval, in my head, if I were to step back even beyond my world, if I say the most too usable, and again, I’m an active person, this is my bias, funds in the market are the interval fund and the active ETF because they’re barbells, and that listed closed-end fund, which is actually my DNA and my backbone, almost, is a beautiful structure.

But there’s so many benefits of an active ETF, and there’s so many benefits of an interval fund. And I always tell fund sponsors to have one or the other. You should have both, because you can sell them differently at different times, different ratios to different advisors. It should be the same advisor, but advisors that do ETFs are usually different than advisors that do interval funds in my personal experience. And so I just think more products and more education, differentiated projects. So prove your wrapper, prove your guts and prove your value. Like, when you’re the only private equity interval fund, you’re pretty good. You know, you’re top of your class. If there’s 10 and you’re the bottom 10 percentile and you’re not as good as you thought you were because now there’s better platforms doing better work, you’re gonna probably liquidate eventually or be bought and repurposed.

Andy: Right. No, that’s, you know, I can’t argue with that. And like you said, it is the nature of capitalism that we’re gonna have sponsors that are gonna come and go. There’s gonna be higher quality products, lower quality products, and it’s really the sponsors with longevity. Sometimes that can make it harder for startup sponsors, you know, but, you know, that’s just kind of a fact of life. I think it’s fair for investors to look at track record and, you know, to evaluate players that are consistently bringing…

John: Excuse me.

Andy: Yeah, quality products to market, you know, with fair fee structures and proving themselves over time. John, I can’t thank you enough for demystifying this stuff. I can’t say that I totally understand all of these product types, but I’m a heck of a lot closer to understanding them.

John: For those that wanna dig in April 19th, I think at 2:00 we do a quarterly research call covering all of this. There’s a live session that’s replayed, there’s a 60-content slide. So this is your fire hose if you like what you’ve seen so far. And then also the activist company alliance is ascalliance.org. We have a weekly podcast. I’m not the host. We have a professional host. We actually sponsor a segment, but Chuck Jaffe does a great job and has me, has my peers, has fund sponsors, and we cover the gamut. And is a 10 to 12-minute digestible bite that I think can be very useful. And I think those are the two best things we’re doing, plus some in-person events and some virtual content over time.

Andy: So, John, where can our audience of advisors and high-net-worth investors go? What’s the main website they should check out?

John: So for what pays my bills, it’s cefadvisors.com and our research site is cefdata.com. But you can link right off the first to the second. And to my separate legal structure that’s, you know, my nonprofit, it’s aicalliance.org. And again, that’s actually a brand-new website. It shows you what I can do if I have to.

Andy: I love it. I love it. I’ll be sure to link to all of that in our show notes, which are always available on wealthchannel.com. John, thanks again for joining the show today.

John: Andy, I appreciate the invitation. I hope to chat in the future.