SPE - SPE: Distribution Set To Decline In 2023

Summary

• The Special Opportunities Fund is a special situations / activist hedge fund in a closed-end fund structure.
• The CEF has generated respectable long-term average annual returns of 6.8% over 10 years.
• However, with a large payout and poor investment performance in 2022, SPE's NAV has shrunk by ~30% YoY.
• This implies the monthly distribution is set to decline by 20% in 2023, as the SPE fund is run on a managed distribution plan of trailing 8% of annual NAV.

True to its name, the Special Opportunities Fund ( SPE ) is a closed-end fund ("CEF") run like a special situations / activist hedge fund. The fund has generated modest long term returns and has an attractive 11.5% current yield. However, the yield is set to decline in 2023 due to the fund's managed distribution plan.

Fund Overview

The Special Opportunities Fund aims to provide total returns to investors by investing in discounted closed-end funds, undervalued operating companies, and other special situations like risk arbitrage and distressed securities.

SPE's stated investment strategy appears purposely vague such that the manager, Bulldog Investors LLP, has carte blanche to invest in almost any securities it deems appropriate.

In fact, going through some of the fund's reports and press releases, it is clear the SPE fund is an activist hedge fund wrapped in a CEF vehicle. For example, within the past year, SPE has sued FAST Acquisition Corp. ( FST ) and Delaware Enhanced Global Dividend and Income Fund ( DEX ) to effect activist policies.

Portfolio Holdings

One complaint I have is that SPE's website has little information on the fund's performance and holdings except links to quarterly reports that has not been updated for Q3/2022, even though we are approaching year-end 2022.

From the latest semi-annual report, we can see that SPE's portfolio is 60% invested in investment companies (i.e., CEFs), 26% invested in Special Purpose Acquisition Vehicles ("SPACs"), and various other investments as of June 30,2022 (Figure 1).

Returns

Using returns data from Morningstar, we can see that the SPE fund has delivered modest historical returns with 3/5/10Yr average annual returns of 5.7%/5.6%/6.8% of NAV, to November 30, 2022 (Figure 2). These figures include the tough environment of 2022, where SPE has lost 8.4% YTD.

Since SPE's strategy is more of a special situations / activist hedge fund than a traditional long-only CEF, we should also view its results through an absolute return lens.

On an annual basis, we can see for the past ~11 years (including YTD 2022), the fund had returned an average of 15.7% in up years vs. average losses of 6.8% in down years. SPE was up 7 years in the past 11 years, or 64% of the time (Figure 3). The 2.3-to-1 win/loss ratio combined with 64% winning probability does look favorable for SPE.

However, investors should also note that the past decade has been one of the longest bull markets in history. A simple market index fund like the SPDR S&P 500 Trust ETF ( SPY ) would have been up 9 out of 11 years (82% win rate) with average gains of 19.4% in up years vs. 11.5% losses in down years, for a 1.7:1 win/loss ratio (Figure 4). Overall, SPY has generated 3/5/10 Yr average annual returns of 7.6%/9.2%/12.4%. So in comparison, SPE's returns look pedestrian.

Distributions & Yield

The SPE fund has a managed distribution plan ("MDP"). SPE currently pays a monthly distribution at an annual rate of 8% of NAV at the end of the prior year or $0.11 / month. This translates to a current yield of 11.5% of market price, or 10% of NAV.

As I commented in my prior article on the Royce Value Trust ( RVT ), I am a supporter of managed distribution policies, as it protects the fund from paying an unsustainable distribution rate that destroys NAV value over time.

However, I have some reservations regarding SPE's chosen 8% distribution rate. If we look at SPE's 10 year average annual returns of 6.8% of NAV, we can see that there is an earnings shortfall of approximately 1% per annum between SPE's returns and its distribution.

In fact, SPE changed its MDP in July 2021 from a 7% annual rate to 8%. This looks like an error in hindsight, as management probably looked at SPE's trailing 10Yr average annual returns of over 9% and concluded paying a trailing 8% rate is sustainable. However, they did not consider that the economic expansion from 2009 had been one of the longest in history, and would flatter any trailing returns figures.

In any event, the increased distribution rate combined with poor investment performance in 2022 has shrunk SPE's NAV by over 30% in 2022 (Figure 5). With the exception of the COVID pandemic, SPE's NAV is the lowest it has ever been, since Bulldog Investors took over management of the fund in late 2009.

The problem for investors is that with SPE's MDP, the distribution is set to decline significantly in January 2023. Based on November NAV of $13.18, an 8% annual distribution would equate to $1.05 / annum or $0.088 / month, a 20% decline from the current $0.11 / month distribution.

Fees

SPE charges a 1% management fee on total assets. This works out to a 1.57% total expense ratio for 2021.

Conclusion

True to its name, the SPE fund is a special situations / activist hedge fund wrapped in a CEF structure. The SPE fund has generated respectable long term average annual returns of 6.8% over 10 years. Although it pays a high current distribution of $0.11 / month or 11.5% current yield, investors should be mindful that the distribution is set to decline in 2023 due to the fund's managed distribution plan.

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