2023-07-28 14:59:27 ET
Summary
- As we approach Q2 business development company earnings, we take a look at First Trust Special Finance and Financial Opportunities Fund - a closed-end fund that allocates primarily to BDCs.
- On paper, the FGB CEF looks like a great buy - take a high-return / high-yield BDC sector, add leverage, active management and a discount, and you should get a great result.
- The reality is very different - a dart-throwing monkey would have outperformed FGB by around 9% each and every year. We'll take the monkey, thank you.
As the Q2 business development company ("BDC") reporting period kicks off, we take another look at the First Trust Special Finance and Financial Opportunities Fund ( FGB ). FGB is one of several funds, though the only closed-end fund, or CEF, that allocates primarily to BDCs. It trades at a 9.8% current yield and a 13.1% discount.
The fund looks fantastic on paper. Take a high-yielding, strong-performance sector like BDCs that has a 9%+ long-term total NAV return, juice it up with active management, leverage, and an ability to allocate to other parts of the market, and then stick it inside a double-digit discount CEF wrapper that further magnifies its yield. What's not to love?
If we do a back-of-the-envelope of roughly 9+% annual long-term return in BDCs, throw some leverage and active management in the mix, we should come up with a total NAV return for FGB that is well into double-digits.
What do we find instead? What we find is beyond odd - the fund has not only underperformed the BDC sector by a country marathon (a country mile is not really an appropriate term here), but it basically has delivered no return since inception.
Defenders will no doubt pounce on this and say that "since-inception returns" are not fair - the fund had a very tough time during the GFC and got hurt by a forced deleveraging, so we should really look at its performance since then.
Apart from the fact that 5Y and 10Y returns don't have anything to do with the GFC, let's have a more granular look.
First let's have a look at a cross-section of BDC returns (for the BDCs that we cover on the service) over the last 5 years. As a technical sidenote, to compare performance on an apples-to-apples basis we need to look at the FGB total NAV returns versus individual BDC price returns because the NAV return of FGB is driven by BDC prices whereas the FGB price is also driven by changes in the discount of FGB as well.
The news here is not very good; in fact it couldn't be any worse. FGB comes in dead last. A monkey throwing darts would score well ahead of FGB managers.
Let's do something else - let's have a look at how FGB performed each year relative to the sector. We highlighted years when FGB outperformed. It managed to outperform in 3 years of the last 16. That's a hit rate of less than 19%. Again, a monkey would have done much better than FGB here. In fact, it's statistically improbable for such a consistent level of underperformance to actually occur without some serious negative alpha.
Sure, the fund's performance over the last 3 years is an impressive-sounding double-digit figure. However, even here it managed to underperform the sector.
Readers who are familiar with our CEF analysis may already know that we have a bias against owning equities or other relatively volatile assets in a leveraged CEF format for a few reasons. First, CEFs aren't great vehicles for these more volatile assets (e.g., CLO Equity, MLPs, stocks, etc.) because of their leverage constraints.
BDCs tend to be more volatile than credit assets. Such a high level of volatility and drawdowns is more likely to drive deleveraging in leveraged CEFs. The fund's shareholder reports clearly show how the fund deleveraged a number of times, locking in economic losses for investors. This is not the only reason for its underperformance, but it is an important one. We can see in the chart above that 2008 and 2020 were massively underperforming years for the fund for the simple reason that its leverage blew up in its face.
The other reason we tend to avoid equity-focused CEFs is that, for the majority of equity CEFs, active management doesn't really seem to work, even outside of the deleveraging issue (most equity CEFs are not leveraged). We have shown several times that most equity CEFs tend to underperform the broad (or the relevant sector) equity indices.
If we put the performance issue aside for the moment, some investors may be attracted to a CEF like FGB because it trades at a discount - about 13% currently - with the view that they can own a bunch of BDCs (that they would otherwise hold anyway) at a discount to their market price. In other words, you can pay 100% for something or 87% for the same thing - why wouldn't you take the 13% discount offered by the CEF since it seems like a free lunch.
It is important to stress, however, that there is no free lunch here. FGB charges investors 1% in management fees (and a bit more in fund expenses), so it should trade at a discount that reflects its fee. As it happens, with BDC yields of around 11%, the fund should trade at least at a 9% discount (in order to compensate for 1/11th of its yield going to the manager rather than the investors). In other words, the 13% discount is not "gravy" - it's pretty much fair value for what the fund does.
Another argument that often comes up for FGB is that investors get "discount on discount" i.e., they buy FGB at a discount and FGB buys its holdings at a discount too. This argument is often carted out by people who don't know a whole lot about the BDC market. If we look at FGB holdings, what we see is that its top 4 holdings are trading at premiums of 148%, 104%, 150%, and 106%, respectively, so the discount on discount thing is not real. And in fact, the broader BDC market is trading at a valuation of right around 100%.
Finally, many investors find the FGB yield of near 10% very compelling as it's on the high side in the CEF space. However, the fund's yield is actually well below the yield of the BDC space, which is closer to 11.6%. So yes FGB has a high yield for the CEF sector, but it's actually low for the BDC sector, which is what the fund holds, and this is despite the fact that the fund has leverage.
Takeaways
The key takeaway here is that investors should come to grips with the fact that First Trust Special Finance and Financial Opportunities Fund has delivered performance that is miles away from what its underlying holdings have delivered. At the very least, investors in the fund (as well as analysts who pitch the fund) should have a view of why its terrible historic underperformance should be any different in the future from what it has delivered in the past. All in all, FGB remains a consistently poor way to allocate to the BDC sector - a function of its structure as well as its management.
For further details see:
FGB: Remains A Pass For Serious BDC Investors