SPE - SPE CEF: Not For Long-Term Investors

2023-04-11 17:32:14 ET

Summary

• Special Opportunities Fund targets special situations like undervalued companies, distressed assets, discounted closed-end funds, SPACs, etc. that are attractively discounted.
• SPE generated double-digit yield and has been offering monthly pay-outs since 2019. It also generated strong long-term average annual returns.
• SPE trades on strong discounts, but that discount to NAV appears permanent. Also, a significant performance gap exists between SPE and S&P 500 index.
• SPE’s expense ratio of 1.57 percent is quite high. The fund itself is leveraged, and the underlying holdings are also leveraged, thus adding more volatility.

~ by Snehasish Chaudhuri, MBA (Finance).

Special Opportunities Fund (SPE) is a closed-end fund ("CEF") of funds that invests in other CEFs investing in public equity and fixed income markets. This fund can be labeled as a special situations fund or an activist hedge fund.

SPE benchmarks its performance against that of the S&P 500 Index (SP500). Its investment objective is to generate strong total returns. In order to achieve this, SPE invests primarily in securities that have opportunities for appreciation. The fund generated strong long-term average annual returns of almost 13.5 percent between 2016 and 2021. SPE generates double-digit yield and offers monthly payout. Even If these factors fail to generate enough attractiveness, investors might get lured by this fund due to its current level of discount to the tune of 17 percent. Only thing they need to consider is the risk factor, because the lucrativeness it offers on a consistent basis seems too good to be true.

SPE targets undervalued companies, discounted close-ended funds, SPACs

SPE was launched and is managed by Bulldog Investors, LLC. The fund was formed as the Insured Municipal Income Fund, Inc. on February 18, 1993. Bulldog Investors specializes in CEF, and also have the legal expertise for engaging in investor activism. Special Opportunities Fund, as the name suggests, targets special situations such as undervalued companies, distressed assets or discounted closed-end funds. SPE also invests in special purpose acquisition corporations (SPACs). SPACs have some unique characteristics and became very popular during the covid-19 pandemic. There are much higher chances of generating abnormal gains through these types of investments. At the same time, these investments bear much higher risks.

Special Opportunities Fund invests in various equity CEFs and fixed income CEFs

Special Opportunities Fund has made significant investments in various equity CEFs and fixed income CEFs. Major CEF investments included Central Securities Corporation ( CET ), SRH Total Return Fund, Inc. ( STEW ), General American Investors Co. Inc. ( GAM ), First Trust Dynamic Europe Equity Income ( FDEU ), Highland Income Fund ( HFRO ), Adams Diversified Equity Fund ( ADX ), Saba Capital Income & Opportunities Fund ( BRW ), BlackRock California Municipal Income Trust ( BFZ ), Dividend and Income Fund ( DNIF ), Neuberger Berman Next Generation Connectivity Fund Inc ( NBXG ), Templeton Global Income Fund ( GIM ), Taiwan Fund Inc ( TWN ), BlackRock ESG Capital Allocation Term Trust ( ECAT ), Eaton Vance New York Municipal Bond Fund ( ENX ), Sachem Capital Corp. ( SACH ), Vertical Capital Income Fund ( VCIF ), Virtus Total Return Fund Inc. ( ZTR ), and Delaware Enhanced Gbl Div & Income ( DEX ).

The good news is that, barring only three funds (ZTR, CET and HFRO), all other funds recorded positive price growth during the past six months. FDEU, TWN, ECAT, BFZ, VCIF, ENX, DEX and GAM - almost half of the above-mentioned funds - recorded double-digit price growth. This growth is remarkable, as the price return of S&P 500 , itself was not in double-digits. Thus, it is no wonder why the Special Opportunities Fund was able to offer strong monthly pay-out on a consistent basis. However, we need to dig deeper into this, as both the price return and total return of SPE are negative during the past six months.

SPE made direct investments in custodian banks trading at strong discount

Direct investments were made in equity stocks of various asset management and custodian banking firms such as CION Investment Corporation ( CION ) FS KKR Capital Corp ( FSK ), and Runway Growth Finance Corp. ( RWAY ) and Portman Ridge Finance Corporation ( PTMN ). All these four stocks are available at discount and have recorded poor price performance over a long period of time. During the past five years these stocks generated a negative price growth between 7 to 38 percent. During the past twelve months that price loss was between 12 to 21 percent. However, the largest direct equity investment of Special Opportunities Fund Texas Pacific Land Corporation ( TPL ) recorded strong price growth throughout. This oil and gas explorer recorded almost 24 percent price growth during the past 1 year and 240 percent growth during the past five years.

Overall, SPE's investments are highly focused on the financial sector. That obviously raises some concerns due to a very high level of inflation and a series of interest rate hikes.

This FoF has a skewed portfolio, low AUM, and very high expense ratio

It will not be wrong to call Special Opportunities Fund an activist hedge fund. The fund also has a very high expense ratio of 1.57 percent and turnover ratio of 54 percent. Such a high expense ratio on a relatively low AUM (assets under management) of $151.88 million surely enhances the risk profile of this fund. SPE's AUM would have been much smaller had it not counted its outstanding $52 million 2.75 percent convertible preferred stock ( SPE.PC ). And on top of that, SPE is skewed towards two sectors - information & communication technology ((ICT)) and financial - as almost 69 percent of its assets are invested in these two sectors.

SPE suits occasional opportunistic trades more than long-term investors

Special Opportunities Fund targets funds trading on strong discounts, and invests in both equity CEFs as well as in fixed income CEFs. These fixed income funds are considered better options during a bear market. The fund generated strong long-term average annual returns of almost 13.5 percent between 2016 and 2021. SPE also generated double-digit yield and has been offering monthly pay-outs since 2019.

Here it's important to note that the fund also paid monthly dividends for almost 15 years in between 1995 and 2009. However, there lies a performance gap between this particular fund and the S&P 500 index. I feel that SPE's objective of taking less risk to get their equity-like returns has not been successful, as the fund seems to be a high-risk fund.

Special Opportunities Fund also invests in undervalued companies and SPACs, that are attractively discounted. Thus, SPE gains further discounts. However, this also means fees on fees. The expense ratio of 1.57 percent is quite high for such small funds. SPE itself is leveraged, and the underlying holdings are leveraged, adding more volatility. Having some activist exposure is beneficial, but at the same time, enhances the fund's overall risk.

The Special Opportunities Fund discount to NAV appears permanent. I doubt catalysts exist to close the discount gap on a sustained basis. Thus, even a 17 percent discount may not be lucrative enough for long term investors. Considering all these factors, I'd say that the Special Opportunities Fund is best suited for occasional opportunistic trades.

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