Diego Thomazini
Ongoing market volatility caused by inflation, rising interest rates, and other factors presents challenges for income-oriented, risk-conscious investors. In this CEF Insights Podcast Episode, Calamos Investments executives Bob Bush and Michael Grant share views on the current market outlook and where investors can find opportunities in alternative equity strategies. Calamos Investments is a leader in alternative equities. Its Long/Short Equity and Dynamic Income Trust (CPZ), was launched in November 2019 and seeks to provide current income and risk-managed capital appreciation. It is the first closed-end fund to feature a global long/short equity strategy as a primary component of its investment focus.
CEFA:
Welcome to CEF Insights. Your source for closed-end fund information and education brought to you by the Closed-End Fund Association. Today, Bob Bush, Senior Vice President and Director of Closed-End Fund Products and Michael Grant, Co-CIO and Head of Long/Short Equity Strategies, both with Calamos Advisors, will discuss the challenges the current market environment presents to income-oriented investors and the potential for a differentiated investment, featuring a long/short equity strategy to address these challenges. Michael is also Senior Co-portfolio Manager of Calamos Long/Short Equity and Dynamic Income Trust, ticker CPZ. CPZ was launched in November 2019 and is the first closed-end fund to feature a global long/short equity strategy as a primary component of its investment focus. Bob and Michael, we look forward to your discussion.
Bob Bush:
Well, thanks. Michael, we mentioned the CPZ is a unique strategy in the closed-end fund space, particularly with the way it uses equities to support an income stream for our investors. Can you please discuss the investment strategy for the fund as well as the components of this strategy?
Michael Grant:
Sure. Well, thank you very much, Bob. Thank you CEFA. This strategy was conceived back in 2019 and it reflected a judgment that the 30 year era of declining interest rates was coming to an end and interest rates had reached levels that were historically low and for investors that need income, and we know many investors have real income requirements, the likelihood that they could achieve their income objectives within traditional fixed income was dwindling. Now, we didn’t anticipate the COVID era and immediately following the launch of the product of course, interest rates went to even lower levels. The lowest levels ever.
But the key assumption, which I think has been shown to be correct is that if investors have an income need, increasingly they would have to look towards the equity world rather than the fixed income world to achieve that aspiration. So the products objective was to deliver a level of income, which in this case is typically 8% annualized yield, and do it within the equity universe rather than the fixed income universe while ultimately still protecting our clients from the risk of capital loss. Now, what we’ve all witnessed in the last year is that capital loss is a real possibility, not just in the equity world, but in the fixed income world. In fact, in the last six months, we’ve seen some of the largest capital losses in both of those universes in many decades. And that is why in addition to the yield objective of the fund, we also have a capital preservation objective.
Now, as we all know, the equity world can be full of blue skies, or it can be full of clouds. And we have the flexibility in terms of our exposure levels to aggressively manage the funds’ exposure to the equity universe. Obviously, especially at times when the clouds appear rather than the blue skies. So, just to give you a few quick bullet points, for the 12 months ending in March 2022, the fund delivered an NAV return, year over year, over those 12 months of 4.9%. And that compares to the return of the S&P of down 4.6%. And it compares to a return of the Bloomberg High Yield Bond Index of down 4.8%. So that’s the kind of outcome that the fund aspires to, and we think it has enormous value to clients, especially in this broadly unusual, low level of yield opportunity.
Bob Bush:
That’s wonderful, Michael. And I might also add that since the fund’s inception in 2019 through 2020 into 2021, very volatile market periods that the distributions have had no components of return of capital. They’ve all been run either through income or for monetization of capital appreciation. And so far in 2022, we’ve had no estimated return of capital as a component of our distribution. So I think again, during those volatile periods, that’s commendable on you and your team. Michael, as a multi-asset strategy, you have a broad range of opportunities in the CPZ investment universe. Talk a little bit about your process, how you evaluate the broad investment universe to develop a workable set of potential investments.
Michael Grant:
Sure. So, the opportunity set is global and it includes both equities and bonds and it’s highly active, flexible, and risk managed. So, our objective is to very carefully go to this global opportunity set of equities and bonds, and look at where the best risk reward is for achieving our clients’ yield objectives. So we have two key components to the fund. We have an equity sleeve, which is structured as a long/short opportunity. And the short’s important to help protect clients from capital risk in the equity universe. And we have a fixed income sleeve. That fixed income sleeve is composed of a high yield component and a preferred equity component. So, when we look at an opportunity, what’s unusual is that we’re looking right across the balance sheet of a corporate issuer. This is very unusual in our industry.
Most in our industry, you have a bond team, or you have an equity team, you have an equity team and then a preferred team and so forth. Whereas what we’re doing is we’re looking at a corporate issuer and deciding, “Do we want exposure to the equity? Do we want exposure to the bond and how do we want to structure that opportunity?” So that selective approach, I think, is a key competitive advantage. The process is ultimately fundamental. It is bottom-up. There’s a heavy component of top-down understanding. So, key questions like, “Where are we in the economic cycle? Where are we in the equity cycle? What’s the implication of today’s inflation level, for example? What is the Federal Reserve doing?” All that is equally a part of our process that comes together to create a holistic portfolio that can generate that 8% type of yield without undue risk.
Bob Bush:
That’s great, Michael. I guess that sets us up really for the next question. How do you employ these specific security selections and allocate those positions as you ultimately build out the portfolio?
Michael Grant:
So achieving income is the first priority. And then the question obviously is, “Where are we in the equity cycle?” And this brings us to a very keen debate today, with respect to what does the downturn in financial conditions imply for the economic cycle? And we have been cautiously positioned in risk assets for much of the past year. And our view is that there was a material, financial repricing risk, and that we had to structure the portfolio to protect our clients from that. So, that’s an example of how our macro view can feed into the type of securities we select and the way in which we get exposure to those securities.
Bob Bush:
So again, as we build upon that, and certainly we’re in a very volatile environment now, a lot certainly going on. What are the key factors or events that would lead you to sell a particular portfolio security or significantly change your portfolio allocation altogether?
Michael Grant:
Well, it’s going to be a shift in fundamentals and ultimately what we’re trying to do, is not avoid risk. If you avoid risk, you avoid return. What we’re trying to do is assess. If we take a unit of risk, are our clients compensated by more than a unit of return? If they are, then we can lean into that opportunity. If they’re not, we lean out of that opportunity. So, probably the most egregious part of the equity world over the last year has been the long duration, growth, and concept parts of the market. And at minimum, we avoided any kind of footprint in that part of the equity world. And that meant we were materially underweight technology and growth versus financials, versus industrial cyclicals, versus energy and commodities. Where the valuation was not as egregious and therefore, if we took a unit of risk, we can anticipate more than a unit of return for our shareholders.
Bob Bush:
CPZ launched at the end of 2019, just on the cusp of a lot of volatility, obviously, that we’ve experienced pretty much since then. You certainly have managed through a lot of this. And again, quite well, given the fact that all of your distribution allocations have not had return of capital, unlike some competitors or other closed-end funds. How did the portfolio adjust as you were going through these challenging periods and really even into today?
Michael Grant:
Well, the fund was launched just before COVID and we certainly did not anticipate the COVID pandemic and that as we all know, led to the sharpest fair market in US history, but as that crisis unfolded, it became very clear to us, that the opportunity set for leaning into equity risk was compelling. And that’s exactly what we did. It’s why the fund was up in 2020, despite the COVID crisis. And we have generally leaned into equity risk up to the end of last year. Now, once the Federal Reserve changed direction, once it decided that free money or free capital was no longer the right policy, it was obvious to us that leaning into equity risk was no longer appropriate. And that was reflected both in terms of our exposures and the kinds of stocks we were willing to buy.
Michael Grant:
As a more general comment, I think it’s fair to say that through the end of last year, we had a bull market in stupidity in parts of the market and in the growth universe more generally. Our industry is about 100 years old and over those 100 years, the best minds have tried to answer, “How do we get our clients to their destination?” And the accumulated wisdom is that the only thing we really have is earnings and cash flow. And if you invest in businesses that do not have earnings in cash flow, all you have at best is a promise or at worst, a Ponzi scheme. So, we have been heightened in our focus upon those businesses where the line to earnings and the line to cash flow is very clear. So if we go back to technology, for example, we look at a stock like Google (GOOG) (GOOGL). There’s a reason why Google is only down 25% from its highs of last year.
Michael Grant:
The reason is that Google has real quality earnings. It’s not that far from 15 times next year’s earnings with a free cash flow yield of 6% plus. And that is something that you can hang your hat on with respect to your interest rate expectations. On the other hand, there’s a big part of that technology universe that has declined far more. It’s lost 50 to 75% plus in price. And despite that decline in price, many of those businesses are nowhere near the point where they can be valued according to earnings or cash flow. So, what I’m expressing is a conviction that there is a right approach, and we need to avoid excesses at certain moments in the cycle. And that’s exactly what we did through 2021. The fund generated its 8% yield. It generated capital returns on its NAV and it did so, by avoiding the most egregious parts of the financial world, which we’ve all noted in the last six months, have completely fallen out of bed.
Bob Bush:
Very helpful, turning the thought pattern a little bit more towards geopolitical issues, monetary policy, the Fed’s begun raising interest rates quite dramatically. Inflation has been high and if that continues, it may continue to force the Fed to be more aggressive then perhaps they originally anticipated. You have a strong opinion on that. We also have significant geopolitical tensions that have added to volatility. Where do you see the investment markets currently? And what is your outlook for the balance of 2022 and into 2023?
Michael Grant:
So, we’ve had a material tightening of financial conditions and that can be translated as very poor returns for both equities and bonds. And we know what the source of all of this is. It’s the crash in the bond markets and the very material shift by the Federal Reserve towards a more hawkish interest rate policy. Now, investors have watched all of this and they have concluded that recession is just around the corner. This deterioration in investor confidence is so pronounced and so widespread that it is consistent with the sort of trauma that investors associate with economic recession. Our view is different. We do not think real economic recession is around the corner. Recession risk is probably not material until 2024 or 2025. We view what is happening as a material re-pricing of financial assets in line with the end of free money, but one that will not lead to a material downturn in either the economy or in earnings.
Michael Grant:
The Federal Reserve has its back to the wall in the sense that it’s behind the curve. It kept interest rates near zero bound, far too long. Its priority is to get rates back to the neutral zone. And until it does this, until it gets rates out of the… let’s call it, the negligent zone and into the neutral zone, its back is to the wall. Once this happens, however, and the silver lining is that the Fed will be there either by late July and certainly by September. We think the Fed is going to pause. And when the Fed pauses, we think the S&P has a chance of recovering at least two thirds of what it has lost, since the peak of last year. And there’s a possibility that beginning this summer, the return for equities will largely mirror the decline that we’ve seen, but on the upside.
Michael Grant:
So, we’re turning positive on the equity cycle. We think the US 10-year-yield has peaked for now. One of the key judgements to make, relates to the question of inflation. Although our world is normalizing and COVID seems to be dissipating, the impact of the COVID crisis upon the economic cycle will still be apparent for several years. We believe that the current high levels of inflation are ultimately transitory and they reflect the deep disruption to supply chains that resulted from COVID. Therefore, we think inflation will gradually, but notably moderate for the next two years. We’re having this conversation in 12 months’ time, for example, we think it will be obvious that there is more disinflation broadly in economy than inflation. So far this year, financial asset prices have been hostage to perceptions of inflation and therefore the US 10-year-yield. To the extent that our forecast of lessened inflation risk is correct, it implies that financial asset prices can stabilize.
Bob Bush:
Now, obviously many of the investors, a good portion of them that invest in closed-end funds, and notably CPZ, are income oriented. And obviously, they’re receiving quite a handsome monthly distribution. What challenges does this current market environment present to those income oriented investors or investors seeking portfolio diversification for traditional fixed income investments, given the market volatility that we see in inflation and rising interest rates?
Michael Grant:
Well, I think that investors everywhere have become addicted to let’s call it the monetary drugs. And equally important is fixed income investors benefited from three decades of price stability, and that era is behind us. So, we think we are entering an era of quasi price instability. Now note, that is not the same thing as a new inflation era. Investors tend to look and say, “Okay, I understand that price stability is behind us, but then they leap to the conclusion that inflation will simply dominate and that’s not true. There’s no question that there will be parts of the economy where there are inflation pressures, but there are still big parts of the economy where there will be deflation pressures. And I think investors have to get used to a degree of fixed income volatility for the next several years that they have not seen in the last 30.
Bob Bush:
We’ve talked a lot about CPZ having a broad range of potential investments, certainly on the fixed income side, on the global equity side. And I think what makes this product obviously different is that while we have these investment opportunities in many different areas, we can also move up and down the equity exposure as you do so well in your part of the portfolio. You’ve called for, I think, sort of a distinction between how certain different sectors perform versus others in the S&P, for certainly different regions. How do you see this active management across this range of potential investments contributing to addressing the challenges, particularly with respect to this market environment?
Michael Grant:
So, I’m going to answer that from a fixed income perspective and then an equity perspective. So, I just pointed out that the fixed income world must get used to rising price instability, and that will create a volatility in fixed income that we haven’t seen in decades. And if we do look at the 1970s, for example, what we saw is big swings in inflation outcomes. So, inflation at the start of the seventies was 1%. It then went to 6%. It then went from 6% to three, and then from three to 12, and then 12 back to six and so forth. So, an active approach to fixed income becomes paramount, when we see that kind of volatility emerge in the inflation side of things. On the equity side of things, I think there’s two components.
The first is like in the 1970s, when you see those big swings of inflation, they immediately translate into big swings in the equity world. The 1970s, depending upon whether inflation was on the upswing or the downswing, markets would go down 40%, then they’d go up 50%, then they’d go down 40% and then up 50%. So again, an active asset allocation becomes critical in that kind of setting. The other point is that this past decade has been especially unusual for US equities, because it was dominated by five or six or seven unusually successful mega cap stocks. The Amazons, the Googles, the Apples, the Facebooks, the Netflixes, they delivered bottom-up fundamentals that were spectacular. And those mega caps dominated the indexes.
And unless you’re willing to put 50 or 60% of your portfolio in those mega caps, it was very hard to keep up with the equity benchmarks. Our view is that the fundamentals of those mega caps are finally differentiating. And we think there’s a chance that two or three of those mega caps enter a period of structural decline. And if that happens, it will change the entire flavor of the equity benchmarks. So, we know passive has been a big winner in the last decade. And the reason is because passive flows, simply go into those top five or six or seven mega caps. If those mega caps can no longer lead, then an active and diversified portfolio has a much better chance of performing versus a passive portfolio. And again, this all leads back into our investment objective, which is to be active and to be flexible and risk managed rather than simply benchmark focused.
Bob Bush:
As we narrow all this down into real time and again, speaking generally, how is the CPZ portfolio positioned and where are you seeing the best opportunities in this market?
Michael Grant:
So, let’s go back to an argument I mentioned earlier. We’re shifting from a world of price stability to an era of quasi price instability. Now, in the era of price stability, corporations did not need to worry about their cost of goods sold. Their labor costs were stable. Their energy costs were stable. Their input costs were stable and every firm therefore, differentiated itself by growing its top line. In a world of quasi price instability, managing your cost of goods sold becomes paramount. So, if we look at some of the problems we’ve seen with recent earnings reports, for example, Amazon (AMZN), or Target (TGT) or Walmart (WMT) or Lyft (LYFT), the problem in those reports was not top line growth. It was the increased difficulty of managing their cost of goods sold. And my view is that this focus on who can and cannot deliver operating leverage in an expanding economy, will be the key differentiation for winners versus losers.
So, we think the businesses in areas such as financials, industrial cyclicals, certain types of consumer cyclicals, a whole range of transport and aerospace businesses. And we can say that some of these are just later to the normalization post-COVID. These businesses that can deliver earnings growth through the later part of this economic expansion have a chance of having their share prices, go up with their earnings. And I think that’s the key judgment to make. Going back to the old winners of the last decade, the technology growth space, will not work if we’re correct that quasi price instability is the new norm. That love affair that investors had with growth stocks at the expense of everything else, cannot work if our pricing assumptions are correct. But the important point is that given the dramatic repricing that we’ve seen in markets in the last six months, we can see a whole range of very compelling, long ideas in the right parts of the economy that can deliver operating leverage.
Bob Bush:
Great. Thanks for that. And lastly… and you and I have talked a number of times about this with clients and prospective clients. As we consider, or clients consider an asset allocation, a multi-asset strategy with a long/short equity focus, which again, CPZ is the only closed-end fund that offers such, how is this product in your opinion, best positioned in an investor’s diversified portfolio, particularly one for an investor that may be more income oriented, like the typical closed-end fund buyer?
Michael Grant:
Sure. So, let’s start with the basic language of our industry, which is the 60/40 model. 60% equities, 40% bonds. Now the 40% in bonds assumes that the yield or income in the fixed income universe is adequate to meet client aspirations. And the problem today is that it is not. So, one naturally is inclined to push more towards a 70/30, or even an 80/20, in order to achieve the return objectives of clients. The problem of course, is that the equity world does have more capital risk. And how do we accommodate for that? My view is that we have to shift more into equities because bonds can’t deliver the returns, but we want to do it in a way that’s risk adjusted.
So, I think if you assume an 80/20 model, I think if you took 20 of those 80 equity points and allocated them to some kind of equity alternative, that makes a lot of sense because at that point, you’re still generating, hopefully the yield. You’re generating the possibility of capital opportunity, but you’re doing it in a more risk controlled way that normally in the past, you might have looked to the fixed income to deliver, but we can’t look to the fixed income world to deliver that. A, because yields are too low and B, because capital risk is now a material factor in fixed income.
Bob Bush:
I think that’s a critical point. And again, the big distinction with CPZ is this long/story strategy, which Michael and his team have managed for over 20 years in a mutual fund construct that lends itself well to the closed-end fund space, where you can actually actively manage the overall equity exposure of the portfolio. And you’re not long all the time. I think it’s been very helpful for us and the team, it certainly speaks to the success of the product. Michael, I want to thank you so much for sharing your thoughts with us today. I’d like to thank the listeners, Calamos clients, and certainly Calamos perspective clients for your interest and your support over the years. Thank you very much.
Michael Grant:
Thank you.
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