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   Interview

    Guest Interview:

   Newgate Capital Management LLC

    One Sound Shore Drive
    Greenwich,CT 06830

    Telephone: 203-661-0700
    Fax: 203-661-4005
    E-mail: webmaster@newgatecapital.com

 

    Interview Quarter: 4Q1994

 George Foot

 Partner

 

Q: What kinds of accounts does Newgate Management offer to its clients?

A: Currently, there are four international and global portfolios available to Newgate clients: International Equity - Invests primarily in the developed stock markets outside the US. Examples of the countries we invest in are represented in Morgan Stanley's Europe, Australia and Far East Index (EAFE). Global Balanced - Invests in both the fixed income and equity market throughout the world including the US. Our benchmark in this instance would be a 60/40 blend of the EAFE Index and the Salomon World Bond Index. Global Fixed Income - Fixed income, both domestic and international funds, our target is the Salomon World Bond Index. Emerging Markets - Invests in the developing stock markets of Asia, the Pacific Rim, Latin American, Eastern Europe and elsewhere. Although there is no true consensus on the benchmark here, we are using Morgan Stanley's Global Emerging Markets Index to gage the performance of this portfolio.

Q: Since you use closed-end funds for your portfolios, would you tell us what a closed-end fund is and what investment advantages it offers?

A: The origin of the closed-end fund as a publicly traded security dates back to the late 19th century. Closed-end funds are the great-grand parents of today's opened-end funds, or mutual funds, and therefore share a number of characteristics. Both represent a pool of securities with a particular investment objective and portfolio manager. Beyond that, the similarities end. Investors who want to purchase shares of a mutual fund enter the order directly with the fund itself. The purchase price is a direct reflection of the liquidating price for all the securities in the underlying pool divided by the number of shares outstanding at the close of business that day. This price is commonly referred to as Net Asset Value or NAV. The assets of a mutual fund and number of shares outstanding will fluctuate daily. Individuals who want to purchase or redeem shares of a closed-end fund will enter the order on an exchange. Unlike an open-ended fund, new money is raised and shares issued only once - in the initial public offering. Once completed, the price will fluctuate independently of the value of the underlying securities. A fund's stock price that is trading above its liquidating value is referred to as trading at a premium. Conversely, a stock below NAV is said to be trading at a discount. Owning either an open- or closed-end fund gives the investor instant diversity over a number of individuals securities. The typical fund will hold between 40-200 separate issues. Newgate equity portfolios will hold between 12-20 closed-end funds and offer a number of distinct opportunities: · True international exposure - Newgate portfolios hold funds investing in markets throughout the world, many of which have been traditionally closed to US investors. They provide access to such opportunities ranging from blue chip shares in major markets to unquoted securities in Hungary.
· Liquidity - With 1000 funds now available in London, New York, Toronto and elsewhere, Newgate can increase or reduce entire country or regional exposure rapidly. One in five stocks on the New York are now a closed-end fund. They are the third largest sector on the London exchange.
· Few surprises - Newgate's ongoing quantitative research includes a 30 year proprietary database in this sector. Our knowledge of these securities and their management teams plays an important role in our buy/sell discipline.
· Discount strategy - Newgate purchases funds at discounts to net asset value, versus paying the full market price for the underlying securities.
Capturing the momentum of the individual markets as well as closing the discounts, has provided higher overall returns for Newgate clients.

Q: What is the history behind closed-end funds?

A: Publicly traded closed-end funds began in the United Kingdom in the third quarter of the 19th century. Known in England as investment trusts, they represent many of the oldest and largest investment companies in the world. Foreign and Colonial, with over $12 billion under management, was investing in the United States when we were an emerging market. US closed-end funds first became popular in the United States during the bull market of the 1920s. Many of these funds disappeared following the crash of 1929 due to highly speculative investments and leveraged portfolios. The renaissance of CEFs began in the mid 1980s in response to strong overseas markets. Country funds, beginning with the Germany fund and Spain fund in 1987, quickly became popular ways for individuals to invest in foreign securities.

Q: How many closed-end funds are there? Also, how many do you use that are on domestic versus international stock exchanges?

A: There are now almost 1000 closed-end funds available on leading stock exchanges throughout the world: On the New York, there are approximately 450, of which 3/4 are fixed income. In London, there are nearly 400. These are primarily equity funds. There are also a handful of funds traded on the Toronto exchange. Other closed-end funds exist but may not be readily available to US investors, e.g. Spanish funds traded in Madrid or domestic Thai funds. For a number of reasons, Newgate equity portfolios primarily hold funds traded in London. In the US, as mentioned above, investors are greatly limited to the number of equity funds they can purchase. In addition, few brokerage firms follow these securities from a research standpoint greatly adding to the confusion regarding these vehicles. The domestic market is dominated by retail investors who are too often chasing yesterday's news. The strongest evidence to this effect is the run up of many of the emerging markets country funds - some trading as high as an 80% premium to net asset value. The discount or premium one is paying for NYSE listed funds can only be estimated throughout the week and is generally published weekly. In London, one may choose from over 400 equity funds, representing many of the world's most experienced global investment firms and management teams. There institutional investors are the norm - in fact, 80% of these securities are held by institutions. The result is that the leading brokerage firms provide in-depth coverage of the funds, managers and their portfolio holdings. In addition, daily or even hourly NAV pricing is available to large players in this market. Unlike a majority of funds on the New York, London funds typically trade at a discount to NAV.

Q: What are the fees associated with closed-end funds?

A: The larger London funds typically charge between 16-60 basis points. It's important to note that most UK funds are slightly leveraged, the average is around 7%, precisely to pay for all their fees.

Q: Why do you use closed-end funds versus investing in stocks directly?

A: One could as easily ask why anyone would buy stocks when they could buy well managed funds at a discount. Newgate capitalizes on our ability to select among the world's finest management firms, many with audited track records of investing globally for generations - or, as in the case of a handful - over a century. With this type of talent readily available, providing a wide range of investment styles and expertise at prices well below the value of the underlying holdings, it is no wonder European investors have routinely bought these securities for their portfolios. Within the sector, Newgate is unique because of our quantitative approach to these funds. Newgate is respected as one of the leading experts in the closed-end fund sector worldwide. This expertise is underscored by the brokerage firms and institutional investors, both here and abroad, who purchase our quantitative analysis of these securities. It was one of Newgate's founding partners, Dr. Sonia Rosenbaum, who first introduced Modern Portfolio Theory to this sector in the early 1980s. An important facet to international investing is diversification. The benchmarks used in comparing performance of any given international fund, will hold between 1500-2000 individual securities. Holding 30-50 stocks with just as many countries to choose from, brings to question just how well diversified many portfolios really are. By holding a portfolio of 12-17 closed-end funds we have accomplished our goal of diversification. This number of funds will represent over 1000 underlying securities. Newgate portfolios are not limited to the variety of markets we can access via these funds - many of which have been, and are still, closed to US investors. Concerns about liquidity, settlement, corporate research, especially in the emerging markets area, are addressed by using exchange listed funds versus buying individual securities in local markets. We are currently purchasing a fund with underlying holdings in Eastern Europe. This fund holds a large number of unquoted securities that are likely to be listed within the next twelve months. Newgate views this as a buying opportunity given the fund's manager, his expertise in this region of the world and its depressed stock price. In addition, the economic growth estimates for this area are very positive at this time. Try accessing this market with an ADR.

Q: How much emphasis do you put on the management of the closed-end funds as opposed to the underlying economic conditions of the country behind the fund?

A: Newgate uses fundamental and quantitative considerations to guide the selection process. We first assess the overall attractiveness of the global marketplace. We then consider the domestic monetary conditions within each country and region and decide where each country is in its investment cycle. Once we have established that this is within reason, we then search out managers with known talents of stock and asset allocation for that area. We are very familiar with most of the London and offshore management groups running these funds. In many cases, we have a personal relationship with the fund manager. Our primary concern in this regard is the stability of the company and its ability to implement its investment discipline. Newgate has had a joint venture agreement with the Association of Investment Trust Companies in London since the mid 1980s. That relationship has given us unique access to and understanding of the closed-end fund sector in London.

Q: How does the currency exchange affect the way you trade your portfolios?

A: One of the obvious reasons for moving assets outside of the US, is currency diversification. Holding a one country, one currency portfolio is a rather risky proposition given our global economy. We address currency exchange by comprehensive diversification. Newgate portfolios typically hold funds with underlying holdings in over a dozen different currencies.

Q: Please describe how your "risk-adjusted quantitative analysis" works.

A: Large portfolios of securities with stable management are very responsive to quantitative analysis - they're very robust numbers. Modern Portfolio Theory statistics - including alphas, betas, standard deviations and Sharp ratios - are used to find the best performers in each category on a risk adjusted basis. Quantitative analysis allows Newgate to objectively measure volatility and returns. Take, for example two funds with similar management styles and objectives. Both have annualized returns of 10% over a 3 year period. One, however, made all of its gains during year three and was actually down in years one and two. The fund two had steady returns throughout the period. Newgate's analysis would clearly favor the latter.

Q: This approach sounds a lot like Modern Portfolio Theory. Would you please explain the fundamentals behind it?

A: Modern portfolio theory statistics measure each investment trust's risk, diversification and risk-adjusted rate of return. They are calculated based on linear least squares regression using the most recent thirty-six months of data. The dependent variable is the investment trust's monthly net asset value total return performance. The independent variable is the monthly return for the relevant market index, such as the Capital International World Index or the Financial Times All Shares Index, with the dividends also compounded. All the overseas market indices used are sterling-adjusted. Following the standard practice, the performance of both the investment trust and the index is reduced by the risk-free return of U.K. Treasury bills. The statistics are as follows: Beta is a measure of the investment trust's volatility relative to a market index. Statistically, beta is the (unstandardized) regression coefficient, i.e., the slope of the regression line. If a trust has a beta of 1.0 against the Capital International World Index, for example, then the trust was as volatile as the market. A beta of .75 means that the trust has moved (up or down) .75% monthly for every 1% monthly move in the index. On the other hand, a trust with a beta of 1.5 was one and a half times as volatile as the market, and the trust had higher risk in relation to the market. Beta measures the portion of an investment trust's risk that is related to the market index being used. R squared: The correlation coefficient (R-squared) measures the percentage of the trust's performance that is due to the market, in relation to the market index used. Statistically it is known as the coefficient of determination. R-squared ranges between 0 and 100 percent, and it is an indicator of the trust's diversification. For example, an investment trust with an R-squared of 60 is 60% as diversified as the index against which it is measured-i.e., 60% of the trust's risk is market-related and the other 40% is attributable to the trust's unique characteristics. Thus, sixty percent of the trust's performance can be explained by the performance of the market. Alpha is an indicator of risk-adjusted return. It represents the difference between the actual performance of a trust and its expected performance, given its volatility (beta) and the market's performance. Statistically, it is the intercept of the regression line, and it is expressed as an annually compounded return. For an example of alpha, assume that the market as measured by the Capital International World Index was up 22%, risk-free Treasury bills earned 10%, and a trust was up 30% with a beta of 1.25. The market's return above risk-free rates was 12% (22% minus 10% for T-bills). A beta of 1.25 means that the trust was 25% riskier than the market, so the trust's return above risk-free rates should have been 1.25 x 12% = 15%. Instead, the trust outperformed T-bills by 20% (30% minus 10%), and it did 5% better than expected, given its risk characteristics. Therefore the trust's alpha was 5%. Simply put, since alpha is the intercept of the regression line, it can be interpreted as the expected performance of a trust when the market's performance is 0. Two other measures of risk calculated without reference to a market index are standard deviation and the Sharpe Ratio. Standard deviation is a measure of the trust's total risk. It indicates the average amount of variation that there was in the trust's monthly performance in relation to its average monthly return (calculated over the prior 36 months). Statistically the standard deviation measures the average dispersion of the trust's monthly returns around its mean monthly return. Standard deviation is expressed as a monthly percentage and is based on total return price performance. A high standard deviation implies that a trust was more risky in achieving its results For example, suppose that two trusts had a total return price performance of 36% over 3 years, where trust A was up 1% every month but trust B was up 10% one month, down 5% the next, up 8% the following, and so on. Trust B was more risky than trust A, and its standard deviation is higher. One can use standard deviation in a relative sense by comparing trusts against each other and also in probabilistic terms. For example, if a trust has a standard deviation of 4%, then its performance in roughly 2 out of every 3 months would be expected to fall within a range plus or minus 4% from its average monthly performance. And in 95% of the months (19 out of 20), its return would be expected to fall within a range plus or minus 8% points (2 x 4%) from its average. The Sharpe Ratio, named after Professor William Sharpe, shows how much risk the trust has taken in relation to its return. It is the average monthly performance above risk-free rates of return, divided by the standard deviation of the trust's monthly performance. The resulting statistic, therefore, is a ratio without measurement units attached to it. The calculations use total return price performance calculated over 36 months, reduced by Treasury bill rates. Higher ratios indicate higher returns relative to the risk taken to achieve those rewards. Sharpe ratios are expressed as proportions, and negative Sharpe ratios indicate that a trust's return for the prior 3 years was below risk-free T-bill rates of return. Since the measure is independent of a market index, it can be used to compare a wide range of investments against one another. However, comparisons of Sharpe ratios are most appropriate for trusts with similar investment objectives.

Q: How do you go about tracking and analyzing the many closed-end funds that you follow?

A: We believe that Newgate has one of the most comprehensive, worldwide closed-end fund databases in the world. We receive feeds from Reuters, various London institutions, individual fund managers and US exchanges that continuously update price and net asset value data.

Q: You also use arbitrage to take advantage of the price differences between similar funds. How does this work?

A: It's a very small part of what we do but, occasionally irresistible opportunities do develop. The biggest problem is borrowing stock in the US given the relatively small size of many of these funds. That limits the amount of arbitrage one can really do.

Q: What causes these pricing disparities between closed-end funds and why don't more people track them?

A: The US funds are largely owned by individual investors, whereas offshore trusts are the exclusive domain of institutional investors. The result is a premium in the US versus a discount overseas - it's really arbitraging unsophisticated versus sophisticated money.

Q: How do you know when to hedge a closed-fund's premium?

A: What prevents a seemingly high premium from becoming even more out of line? As in our investment portfolios, it's driven by proprietary, quantitative discipline that uses a number of variables including discount, momentum and other technical inputs.

Q: George, what is your background and how did you get into money management?

A: I am a founding partner and senior portfolio manager of Newgate Management Associates. I have managed global investment portfolios since 1972. Academically trained as a historian, I have published essays on history, science and investment in the Encyclopedia Britannica, American History, World Financial Review, The New Englander and Medical Economics. My comments on international markets regularly appear in leading financial publications.

Q: I understand Dr. Sonia Rosenbaum, your wife and founding partner, has a background in statistical research. Where did she get her training in statistical analysis and its application to investments?

A: Dr. Rosenbaum is a founding partner and Research Director of Newgate Management Associates. She is a Ph.D. statistician from Purdue University, and has authored four books on statistical analysis and research methods, including Quantitative Methods and Statistics (Sage Publications, 1979). Before founding Newgate in 1982, she was a professor at the University of Massachusetts. Dr. Rosenbaum is one of the country's leading investment risk analysts. Her research on the UK closed-end fund sector is distributed by Warburg Securities of London.

Q: You have more recently opened an emerging markets portfolio. Do you use the same strategy to manage it?

A: Yes, its fundamentally the same discipline. By using closed-end funds, however, we are sidestepping many of the problems facing other investors - while reaping the benefits of these dynamic regions.

Q: How many clients do you have and what are your total assets under management?

A: Around 300 separate accounts totaling some $275 million.

Q: Is there an upper limit to how much money you could manage using this technique?

A: The total market capitalization in this sector is now over $250 billion with new funds coming to market almost weekly. We believe that Newgate can comfortably manage 1% of that, roughly $2.5 billion.

 
 
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