GUG: Discount Widens And Keeps This Fund Interesting

Written by Nick Ackerman, co-produced by Stanford Chemist.

I recently highlighted that Guggenheim's Active Allocation Fund (NYSE:GUG) could be a much safer alternative for holding than the Guggenheim Strategic Opportunities Fund (GOF). The distribution seems more reasonable, and it offers investors a similar portfolio from the same investment managers at a much better valuation. Both funds, being primarily weighted in fixed-income investments, have been under pressure with interest rates rising, and both are leveraged. GUG still remains the more attractive fund when looking at the two.

The Basics

• 1-Year Z-score: -1.40
• Discount: -14.23%
• Distribution Yield: 10.75%
• Expense Ratio: 1.88%
• Leverage: 17.51%
• Managed Assets: $618.119 million
• Structure: Term (anticipated liquidation date of November 22, 2033)

GUG's investment objective is "to maximize total return through a combination of current income and capital appreciation." To achieve this, the fund will "pursue both a tactical asset allocation strategy, dynamically allocating across asset classes, and a relative value-based investment strategy, utilizing quantitative and qualitative analysis to seek to identify securities with attractive relative value and risk/reward characteristics."

In doing this, the fund's "sub-adviser seeks to combine a credit-managed fixed-income portfolio with access to a diversified pool of alternative investments and equity strategies." Allowing them to invest in both fixed-income and equities means they are going to be quite a flexible fund, leaving the management to invest where they see fit. So far, the fund has tended to favor a heavier weighting to fixed-income investments, as we had suspected would be the case.

The fund is leveraged, and the interest rates on the reverse repurchase agreements have risen rapidly as rates were increased. As of their last report, the interest rates were between 2.9% and 5.55%, with the average rate being 3.92% for the year ending May 31, 2023.

The fund has also incorporated borrowings that are based on SOFR plus 0.75%, 0.80% or 0.85%. The spread is determined by the security type that is pledged as collateral. Given the fact that SOFR is at 5.31% today, these borrowings are costing them around 6.10%.

Those leverage expenses have caused the fund's total expense ratio to balloon to 3.45%. However, with some floating rate exposure in the fund, the net investment income ("NII") ratio has still increased.

The fund has also taken down some of its leverage from where it was at its fiscal year-end when total borrowings were closer to $200 million.

Discount Opens Wider

Since our previous update on GUG, the fund has seen weak performance as interest rates once again start surging higher.

The fund isn't overly interest rate sensitive if we compare it with some fixed-income portfolios with a mostly junk-rated portfolio; it helps keep a lower duration that comes in at 3.98 years. This duration is also lower once again than where it was in our prior update, which was reduced from the update prior to that.

All that being said, clearly, as a fixed-income portfolio, there is interest rate sensitivity. We also should consider the credit risk in a lower-rated investment portfolio that's primarily comprised of high yield. Mix in some leverage, and there are definitely risks to consider with this fund. So seeing the fund's management reducing the fund's leverage, I believe, is a positive move in this current environment.

As I said, it's a much better-looking fund that seems materially safer than the position that GOF is in. With that, it isn't necessarily the most attractive fund to consider either. It's discount is really what is the fund's primary selling point, in my opinion.

In fact, the fund's discount went from around -11.5% to -14.23% as of the last close. That was one of the driving forces for seeing the fund's total returns negative as the portfolio, as measured by the fund's total NAV performance, had held up better.

At this time, GUG is trading near its all-time low discount once again. Of course, we only have a fairly short period of time for this fund as it only launched at the end of 2021.

Overall, the fund launched at a pretty terrible time. Combining that with the fund's discount-expanding material - as we often see with CEF IPOs - and that's why the results since inception have been so poor. As we are nearing the end of the rate hiking cycle, that should bode well for GUG going forward. When interest rates stabilize, we could see GUG start to stabilize.

Since the fund's launch, GUG has underperformed GOF significantly, which could be an argument against making a switch to GUG.

However, on a YTD basis, the fund's total NAV returns have been fairly similar. Through this period, overall results on a total NAV return have hugged closer together. That's what makes the argument that a switch to GUG makes a lot of sense. We've already seen that GUG has even been able to outperform on a total share price basis, as some of GOF's premium has been deflated. Further deflating for GOF and/or some discount narrowing for GUG would further see this play out going forward.

Distribution Coverage Lacking

This is another area where GUG looks better in terms of having a more manageable distribution rate relative to GOF. GUG has a distribution rate on the NAV of 9.22% compared to GOF's 18.61%. That being said, the coverage still isn't great here.

On a per-share basis, NII had worked out to $0.79 in the prior fiscal year period. Against the monthly $0.1188 annualized out to $1.4256, we can start to see what the issue is.

On the other hand, this fund's flexibility can produce some capital gains if management is successful. This isn't just in the fund's equity sleeve, which is fairly small right now anyway. This would be through the various derivatives, including swap agreements, futures contracts, and both written and bought options.

The gains from these contracts helped offset some of the realized losses they took on their underlying portfolio.

For tax purposes, the fund is primarily invested in fixed income and should see quite a bit of its distribution classified as ordinary income. That was the case last year and the partial inception year as well. However, the fund has also classified some meaningful parts of the distribution as long-term capital gains and even return of capital distributions in the prior year as well. With a lack of coverage and declining NAV, this would be technically destructive ROC.

GUG's Portfolio

The "active allocation" name of the fund provides the fund with the flexibility to invest where they see fit as to where the best opportunities are coming from.

Generally speaking, the fund has held mostly fixed-income since its launch, and I don't expect that to change too drastically anytime soon. This could be viewed as a multi-sector bond fund, at least currently. I believe this to be the case because GOF also provides flexibility to invest in equities, but it primarily invests in fixed-income as well. Additionally, with a higher rate environment, fixed income offers more compelling yields these days.

Since I started covering this fund earlier in 2023, this weighting has been fairly consistent as well. At the end of 2022, the fixed-income allocation accounted for 85.52% of the fund, with an equity sleeve at 9.79%. Meaning we haven't seen a material change in almost a year now.

This also includes when we take a look at what sorts of fixed-income investments the fund is carrying. The fund has tended to favor high-yield corporate bonds but also incorporates a fair bit of bank loans and asset-backed securities as well.

The bank loans and the fund's ABS are primarily where the floating rate exposure is coming from for this fund. Those are the securities that would have benefited the most when the Fed was increasing interest rates aggressively, as their yields would have climbed materially.

With being near a peak for rates, that isn't so much a benefit going forward in terms of seeing higher NII - however, as their portfolio starts to mature and if they invest it in now higher-yielding fixed-income instruments, that could help. With a mostly junk-rated portfolio, the maturities here are going to be generally shorter than their investment-grade counterparts.

The fund is highly diversified, with 1331 holdings. However, as we covered previously, most of these have incredibly limited sway on the fund's performance. They hold hundreds of equity positions that are valued at less than $100 of total assets. It's a fairly unusual strategy, and I'm not sure entirely what the point is. GOF similarly has a massive number of holdings, but each position has a more worthwhile weight in each position.

That being said, the top ten holdings also reflect being fairly diversified, with no position representing a significantly overweight allocation. When considering these holdings, several of the top positions, such as CIFC Funding, a CLO position, holds hundreds or thousands of other pooled loans within the security. So, if it was broken out into each exposure, we could probably see a similar sort of weightings that they have for hundreds of their equity positions.

Conclusion

GUG is an interesting fund due to its dynamic approach, though only time will tell how truly dynamic this fund will be. What makes GUG a more interesting fund at this time is the fund's deep discount. It is also an alternative for GOF investors who want a similar strategy from the same fund sponsor.

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