FSD: 4 Reasons Why I Would Avoid This CEF

The First Trust High Income Long/Short Fund (FSD) is a closed-end fund (“CEF”) which provides exposure to high-yield bonds. FSD is a relatively unique CEF in that it employs a long/short strategy.

The fund’s long positions may total up to 130% of the fund’s managed assets while the fund’s short positions may total up to 30% of the fund’s managed assets.

While the fund has delivered solid returns since inception there are four reasons why I would avoid this CEF right now:

1. High management fee

2. Weak historical risk adjusted performance compared to high yield index funds

3. Discount to NAV is in line with historical norms while most other CEFs are trading at historic discounts to NAV

4. Potential 2024 merger with abrdn Income Credit Strategies Fund represents a major strategy shift

1. High management fee

FSD charges a management fee of 1.00% and has other expenses of 0.16%. Thus, the total expense ratio as a percentage of net assets of 1.16%. This represents a fairly high fee even for an actively managed product. The average expense ratio for bond mutual funds is ~0.37% while the average expense ratio for bond ETFs is ~0.11%. The iShares Broad USD High Yield Corporate Bond ETF (USHY) offers exposure to high yield bonds and charges a net expense ratio of just 0.08%. In terms of active high yield fund comparisons, the Franklin High Yield Corporate ETF (FLHY) charges a total expense ratio of 0.40%.

Per Morningstar data, just 28.3% of active high yield bond funds have outperformed their benchmarks over the past 10 years. However, the picture improves significantly when segmenting active managers based on cost. 46.4% of active high yield funds in the lowest cost quintile have outperformed their benchmark while just 6.5% of high yield funds in the highest cost quintile have outperformed. This difference in active success rate between high cost and low cost managers is the largest among all fund categories that Morningstar monitors. In my view this data suggests that the level of fee is an important indicator of potential relative success for active high-yield funds compared to passive benchmarks.

For this reason, I view FSD’s 1.16% total expense ratio as an important negative when considering an investment in the fund as investors have many low cost ETF high-yield products to pick from.

2. Weak historical risk adjusted performance compared to high yield index funds

In terms of total return performance, FSD has done a fairly solid job historically. As shown by the chart below, since inception, FSD has delivered a total return of 76.7% which is slightly better than the return delivered by its passive peer the SPDR Bloomberg High Yield Bond ETF (JNK) which has delivered a total return of 76.1%. However, total return is only half the picture as investors must also consider risk adjusted performance.

On a risk adjusted basis, FSD’s historical performance becomes much weaker. Since inception, FSD has realized an average 30 day volatility of 11.3%. Comparably, JNK has realized an average 30 day volatility of 6.9%. Thus, FSD has experienced almost double the amount of volatility that JNK has experienced. Furthermore, the additional level of volatility has been fairly constant throughout FSD’s history. Since inception, FSD has delivered an average 3 year sharpe ratio of 0.45. Comparably, JNK has delivered an average sharpe ratio of 0.53 over the same period.

3. Discount to NAV is in line with historical norms while most other CEFs are trading at historic discounts to NAV

One of the reasons why FSD has exhibited so much added volatility is the fact that the fund has traded at a wide range of discounts to NAV. In 2020, the discount widened to more than 20% for a short-time. By the end of 2022, the discount to NAV was almost 0.

Currently, FSD is trading at a 9.6% discount to NAV which is essentially in line with the fund’s average discount to NAV since inception. I view the level of a CEF’s discount relative to its historical average a more important valuation metric than discount on an absolute basis. The reason for this is that CEFs typically trade at varying discounts to NAV based on underlying factors such as the liquidity of the fund itself and liquidity of underlying assets. Thus, a CEF’s average historical discount to NAV is a reasonable assess of what a fair discount should be on a go forward basis barring any specific catalyst such as a conversion to a mutual fund structure or aggressive repurchase program.

Additionally, it must be noted that CEFs are generally trading at well above average discounts to NAV right now. The average CEF is currently trading at a ~9.2% discount to NAV which represents a 93rd percentile level of cheapness in terms of discount to NAV. For context, the 20 year average CEF discount is ~5%.

Due to this dynamic, I believe there is potential for FSD’s discount to NAV to boost as investors have opportunities to buy other CEFs at a more substantial discount relative to their average historical discount to NAV. For example, consider a fund such as the Nuveen Variable Rate Preferred & Income Fund (NPFD). NPFD is currently trading at a discount of 15.4% to NAV compared to a historical average of 9.5%.

For these reasons, I do not find FSD’s current discount to NAV as highly attractive and believe investors looking to buy CEFs at discount to NAV have better alternative opportunities to buy other CEFs trading at historical levels of cheapness.

4. Potential 2024 merger with abrdn Income Credit Strategies Fund represents a major strategy shift

On October 23, 2023 First Trust Advisors announced that its Board of Trustees had approved a proposed reorganization of FSD into an acquiring fund, the abrdn Income Credit Strategies Fund (ACP). Shareholders of FSD will vote on the proposed reorganization at a special meeting which is targeted for February 2024. The transaction also requires approval from ACP shareholders to issue additional shares. This meeting is scheduled in January 2024. If approved, the reorganization is expected to be completed in Q1 2024.

If the deal is approved, FSD shareholders will acquire shares of ACP with an aggregate NAV equal to the NAV of FSD.

Prior to the announcement of the transaction ACP shares had been trading at a ~13% discount to NAV which was roughly in line with the discount to NAV that FSD had been trading at. Following the announcement of a potential transaction, the discounts of both funds have narrowed and ACP now trades at a 4.3% discount compared to a 9.6% discount for FSD.

While it may appear that FSD shareholders have potential to gain from the transaction as the discount to NAV will converge to ACP’s discount level. This is highly uncertain as ACP’s discount may substantially widen upon consumption of the transaction if shareholders establish to sell. Currently FSD has total managed assets of $559 million while ACP has total managed assets of $483 million. Thus, FSD is actually the larger fund and the discount of ACP may actually widen to become closer to FSD if the deal is approved.

Another thing FSD shareholders must consider is that ACP represents a much different strategy. ACP is a levered long only strategy with ~75% of exposure outside of the U.S. while FSD has 85% exposure to the U.S. Furthermore, FSD is focused on higher quality credits with 67% of the fund invested in BB or better credits. Comparably, ACP has just ~20% of its assets invested in BB or better credits. ACP also represents a higher fee vehicle as the fund charges a 1.89% management fee on net assets.

Given the differences in fund strategy and the fact the ACP is the acquiring fund, I expect many current FSD shareholders will want to sell as opposed to continuing to own ACP following the transaction.

Conclusion

FSD represents a relatively unique CEF that attempts to produce alpha through long/short exposure to high yield bonds.

The fund has a very high management fee which is a significant headwind given the fact that high cost high yield funds have struggled to beat their benchmarks over long periods of time.

FSD’s risk adjusted performance since inception has been weak vs high yield index ETFs.

FSD trades at a substantial discount to NAV but a discount which is in line with the fund’s historical average. This level of discount is not appealing at a time when many CEFs are trading at much wider discounts to NAV relative to their historical norms.

A proposed reorganization of FSD into ACP in early 2024 would represent a substantial shift in strategy. While the current discount to NAV suggest that FSD shareholders may benefit from a reduced discount post reorganization, I am less convinced.

FSD is the larger fund and thus it is unclear why the discount will converge to the level that ACP currently trades at. Moreover, ACP’s discount to NAV has been highly volatile and may widen from current levels prior to the completion of the proposed transaction.

For these reasons, I rate FSD a sell and believe investors should avoid this CEF in favor of other lower fee high yield alternatives.