SOR - SOR: Robust CEF Effective 60/40 Retirement Fund

2023-11-27 15:07:06 ET

Summary

• Source Capital is a closed-end fund that seeks to provide total return to its shareholders through a combination of capital appreciation and investment income.
• SOR invests in a diversified portfolio of equities and fixed income securities, with a global focus on the equity side.
• SOR has a strong track record of outperforming simple 60/40 ETFs, but it is not leveraged.
• The fund is an effective retirement fund tool with a low standard deviation when compared to the S&P 500 and active management.

Thesis

Source Capital ( SOR ) is a closed-end fund that aims to pursue a 60/40 allocation via its portfolio build. The CEF seeks total return via both capital appreciation and investment income. As per its literature, the fund:

Under normal conditions, 50-70% of the Fund’s assets will be allocated to equities , and 30-50% allocated to public and private credit of varying quality. The Fund will invest in public equities of large businesses from around the world (typically with market capitalizations in excess of $10 billion). Allocation to fixed-income will increase in the absence of compelling equity opportunities. Deep research - independent, bottom-up, fundamental research process seeking to minimize risk.

As per its objective, the fund has a dynamic allocation to the equity/fixed income sleeves, with the respective percentages varying depending on the asset manager's view on the valuations for each market. Currently 40% of the CEF's portfolio is invested in equities, with the rest allocated to fixed income sleeves:

I believe the current allocation translates into the SOR portfolio managers being of the opinion equities are not attractive in comparison to fixed income, thus the low allocation to the asset class, that is even lower than the bottom barrier for the 'normal conditions' status.

The CEF has a global focus on the equity side, with 18.9% of the portfolio allocated to non-U.S. equity names. On the fixed income side, the fund has the largest allocation to private credits, which has helped it navigate a rising rates environment via floating rate features. To note that currently the CEF has a small allocation to government securities when compared to traditional 60/40 funds. To that end the vehicle has managed to outperform traditional 60/40 funds, being net positive since the beginning of the Fed's tightening cycle:

We have plotted SOR in the above table against a simple 60/40 ETF, namely the iShares Core Growth Allocation ETF ( AOR ).

We have covered this name around a year ago here , where we did a deep-dive into the fund's drawdown profile versus other 60/40 CEFs, and derived robust analytics for the fund versus its cohort. The CEF has done a tremendous job in navigating one of the steepest interest rate hike periods in history, and has proven its viability as a long term retirement portfolio tool. With peak rates likely now behind us, putting new capital to work in a 60/40 portfolio is a good strategy to pursue, especially via robust long term compounders like SOR which has proven its mettle during one of the toughest stretches for fixed income.

Analytics

• AUM: $0.32 billion.
• Sharpe Ratio: 0.56 (3Y).
• Std. Deviation: 10.5 (3Y).
• Yield: 6.3%.
• Premium/Discount to NAV: -8%.
• Z-Stat: 0.56.
• Leverage Ratio: 0%.
• Effective Duration: 1.9 years
• Composition: 60/40 Portfolio

The analytics speak to the 60/40 allocation feature for the CEF, with the portfolio exhibiting a low standard deviation of only 10.5% when compared to SPY's 18% number.

Investors can still access this CEF with a discount, with the fund's market price 8% lower than its NAV currently.

Dividend hike

The fund's yield is 6.3%, and has been hiked in 2023:

LOS ANGELES--(BUSINESS WIRE)-- The Board of Directors of Source Capital, Inc. ((SOR)) (the “Fund”) today approved increasing the Fund’s regular monthly distribution rate 12.6% from $0.185 ($2.22 annualized) to $0.2083 ($2.50 annualized) for each of the next three months as follows:

The CEF is run very conservatively from a distribution stand-point, which makes it a great long term holding via its NAV accretion features:

A cornerstone of retirement investing is a steady stream of income from a reliable source. Many CEFs use high, unsupported distribution yields to hide decreasing NAV levels. As a retail investor one needs to stay away from such vehicles.

Performance

The CEF has posted a total return in 2023 in line with the simple 60/40 ETF iShares Core Growth Allocation ETF:

However, long term SOR does outperform the simple vanilla ETF:

There are a number of things to observe in the above graph. Firstly SOR outperforms AOR on a decade long basis, and secondly it does so on a consistent basis (i.e. the purple line is above the orange line throughout time).

The story here to digest is that SOR is not a better tool just during certain periods of time, but a constant outperformer when compared to the vanilla AOR allocator.

Holdings analysis

On the equity side the fund holds 50 names, the top ten of them making up 50% of the equity holdings:

To note that the 19.5% total in the table above is in reference to net assets, thus with equities representing 40% of the total portfolio, they come up to roughly half the equity exposure. Outside Alphabet, the fund does not have a significant exposure in any of the tech mega-caps.

On the fixed income side the closed end fund is overweight below investment grade credits:

'BB' and below represent 39% of the portfolio, while the 'Not Rated' bucket is reflective of the private credits which do not get assigned public ratings by the large agencies. Even when looking at the investment grade side of the portfolio we can notice the fund does take credit risk, with its holdings being in the riskiest bucket, namely the 'BBB' names.

However the CEF has taken very smart duration risk, with a low 1.9 years effective portfolio duration, a feature which has helped it navigate a tough environment for fixed income securities in the past two years.

Despite rumors of its demise, the 60/40 portfolio is a viable forward build

After a very tough 2022, the 60/40 is in the black for 2023:

The 60/40 portfolio, a traditional asset allocation strategy, has been facing challenges due to recent economic and market developments, with a violent bear market in fixed income since the beginning of 2022. Moreover, the inflation driven bear market in fixed income changed the historic negative correlation between bonds and equities, with both asset classes down in 2022.

With most analysts of the belief the Fed is done hiking , and the forward SOFR market pricing in rate cuts for 2024, the forward looks bright for the 60/40 composition. If economic conditions deteriorate and the Fed is forced to cut rates, bonds are well positioned to gain in value while equities retrace. This is in stark contrast to 2022, where Fed hikes and persistent inflation brought down both asset classes.

Conclusion

SOR is a dynamic 60/40 portfolio in a CEF format. The fund is not leveraged, and has managed to outperform simple 60/40 ETFs like AOR in the past decade. To note SOR has a dynamic allocation, and its equities/fixed income holdings will vary depending on the portfolio managers' views on valuation attractiveness for each sleeve. Its active management helped the fund go overweight floating rate debt during the worst fixed income bear market in recent history, feature which has helped the CEF outperform in the past two years.

The CEF's exposure on the equity side is conservative, with the fund not chasing performance via high P/E names that are present in the tech mega-cap space. Currently 40% of its portfolio is in global equities, slightly underweight this asset class versus traditional allocators.

With peak interest rates behind us, the viability of the 60/40 portfolio comes again into focus, with this allocation having delivered low volatility results in the past decades. SOR is an active, smart play in the sector, which has proved its mettle during the worst recent stretch for the fixed income market, with the CEF now in the black on a total return basis since January 2022. We believe new capital should now be deployed toward this strategy in 401k accounts, and SOR is an attractive fund to use.

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