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Last year, I predicted that the Special Opportunities Fund (NYSE:SPE) would have to cut its distribution in 2023. Based on the November 2022 NAV of $13.18, I estimated SPE’s monthly distribution would be cut to ~$0.088.
Sure enough, the SPE fund cut its distribution in early 2023 from $0.11 / month to $0.0867 / month, almost bang on with my estimate (Figure 1).
Figure 1 – SPE fund cut its distribution in 2023 (Seeking Alpha)
Did I have a crystal ball to foresee the distribution cut? No, I simply paid attention to the fund’s structure and setup. Since we know the SPE fund pays a managed distribution (“MDP” policy) with an annual rate of 8% of the prior year’s NAV, by December, we usually have a good sense of what the next year’s distribution will be.
Currently, with the SPE fund trading at a recent weekly NAV of $14.27, we can say with moderate confidence that 2024’s distribution will increase to roughly $1.14 per year or ~$0.095 / month (Figure 2).
Figure 2 – Recent SPE NAV (specialopportunitiesfundinc.com)
However, a fund’s distribution yield should not be the sole consideration as to whether it is a good investment or not. Investors should also consider a manager’s total returns track record, as well as the suitability of a fund’s strategy, in deciding whether to invest.
With a year gone by, let us revisit our initial thesis on the SPE fund and determine whether the SPE fund is likely to perform well in the coming year.
Brief Fund Overview
The Special Opportunities Fund invests in discounted closed-end funds (“CEF”), undervalued operating companies, and other special situations like risk arbitrage and distressed securities in order to generate absolute returns to investors.
In terms of strategy, the SPE fund most resembles an activist hedge fund, as it routinely invests in underperforming CEFs and agitate for change. SPE benefits when its underlying investments appreciate as well as when its discount to net asset value (“NAV”) closes.
The SPE fund does not disclose its holdings on a daily or weekly basis. Instead, investors must rely on outdated holdings disclosures from its annual and semi-annual reports. As of June 30, 2023, the SPE fund had 67.5% of the portfolio invested in other investment companies (i.e. CEFs), 16.5% invested in SPACs, 8.1% invested in money market funds, and 3.2% invested in common stocks (Figure 3).
Figure 3 – SPE holdings, June 30, 2023 (SPE 2023 semi-annual report)
Compared to the portfolio composition from my last article, we can see that the SPE fund has reduced its allocation to SPACs from 25.6% to 16.5%, and has reduced its single stock holdings from 8.3% to 3.2% (Figure 4).
Figure 4 – SPE holdings, June 30, 2022 (SPE 2022 semi-annual report)
I believe the reduction in SPE’s SPAC allocation is simply a reflection of the reduced opportunity set in that asset class, as the SPE fund was most likely investing in discounted SPACs to earn high annualized yields if/when those SPACs failed to find an acquisition target and had to return capital to investors.
Since the SPAC bubble burst, the number of outstanding SPAC deals has decreased dramatically and the opportunity set is much lower than last year.
The reduction in common stocks and the addition of money market funds reflects caution, as stocks are nearing all-time highs while money market funds provide decent risk-free yields.
Returns
After an uncharacteristic poor 2022, 2023 looks set to be one of the better years for the SPE fund, as it has returned 18.5% to December 27, 2023. Strong 2023 performance has boosted SPE’s trailing 3, 5, and 10-year annual performance records to 6.4%, 7.8%, and 5.4% respectively (Figure 5).
Figure 5 – SPE historical returns (morningstar.com)
As an absolute return fund, SPE’s performance is decent, as it has delivered positive returns in 8 of the past 12 years (including YTD 2023), with average up-year returns of 16.1% and average down-year returns of 7.0%. The 2.3-to-1 win/loss ratio combined with 67% winning probability looks fairly favourable.
However, as I mentioned previously, we have been in one of the longest bull markets in history, and a simple passive index fund like the SPDR S&P 500 ETF Trust (SPY) would have been up 10 out of the past 12 years with an average gain of 19.7% and an average loss of 11.3% for a 1.7:1 win/loss ratio and 83% winning percentage (Figure 6).
Figure 6 – SPY annual returns have been better (morningstar.com)
The key is that the SPE fund does not appear to generate positive returns when the SPY ETF is down (2018 and 2022), so from my lens, it appears to be a fund positively correlated with the markets with lower-than-market returns.
SPE vs. CEFS
With respect to CEF activism, I recently wrote a review of the Saba Closed End Funds ETF (CEFS), noting that it was one of my preferred ways to invest in the closed-end funds space. How does SPE compare against CEFS?
First, in terms of fund structure, the SPE fund does charge a lower expense ratio of 1.57% vs. 2.42%. The two funds are roughly the same in size (Figure 7).
Figure 7 – SPE vs. CEFS, fund structure (Seeking Alpha)
Also, we should note that the SPE fund currently trades at a steep 18% discount to NAV whereas the CEFS is an ETF and trades roughly at NAV (Figure 8). However, SPE has consistently traded at a discount, and there are announced catalysts that will change this in the near term.
Figure 8 – SPE trading at a steep 18% discount to NAV (cefconnect.com)
When it comes to fund performance, CEFS appears to have performed better, with 3 and 5-year returns of 9.2% and 10.1% respectively to November 30, 2023, compared to SPE’s 6.4% and 7.8% (Figure 9).
Figure 9 – CEFS historical returns (morningstar.com)
Finally, with respect to distribution yield, the CEFS ETF is forecasted to pay a monthly distribution of $0.14 or 8.8%. As mentioned at the beginning of this article, I expect SPE to announce 2024 distributions of ~$0.095/month or a forward yield of 9.7%.
Overall, for investors looking to play the CEF-activism theme, I believe CEFS may be a better fund, as it has historically performed better than SPE.
However, since the SPE fund is trading at the widest discount in the past 5 years, we may see some potential catalysts for a narrowing of the discount. First, the distribution increase could spur some investor interest. Furthermore, SPE has scope to initiate a share buyback funded by cash/money market investments on hand.
Conclusion
With a solid performance in 2023, the SPE fund looks set to increase its distribution by ~9.5% to an annualized $1.14 in 2024. This may be a much-needed catalyst to help the SPE fund narrow its historically wide 18% discount to NAV.
Furthermore, with the SPE fund accumulating significant cash/money market securities in its portfolio, I believe there is scope for the SPE fund to initiate a stock buyback to help close the fund’s discount to NAV.
I am raising my rating on the SPE fund to a buy on these 2 potential catalysts.
