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This Activist Built One of the Foundations of Passive Investing

Art Lipson targets closed-end funds that he says betray investors. He also created the bond market’s most widely used benchmark.

By Brian Chappatta

(Bloomberg Markets) --Art Lipson couldn’t have picked two more distinct ways to shake up the bond market.

Back in 1973, Lipson first made a name for himself by creating the bond index that grew into the Lehman Brothers Family of Indices. Now the Bloomberg Barclays Indices, they’re the benchmarks for many of the world’s largest fixed-income mutual funds. Among the funds that track them are those of Vanguard Group, the pioneer of low-cost indexing as an alternative to higher-fee active strategies.

These days, Lipson also targets fund management costs—and entrenched managers—from his perch at Western Investment, the Salt Lake City-based hedge fund he founded in 1997. As an activist investor, he’s crusaded against certain closed-end funds that he thinks ignore shareholders’ interests in favor of raking in fees. “They violate their fiduciary responsibility to shareholders on a continuing basis,” says Lipson, 73. “I realized I could get these fund companies to respond quickly if I challenge them and keep their feet to the fire, showing they could get voted out if shareholders are unhappy.”

Closed-end funds, according to Lipson, are an “obscure little backwater” of the global financial markets. There were 563 closed-end funds in the U.S., overseeing a total of $251 billion in assets, as of Nov. 10, according to data compiled by Bloomberg. The funds raise money by selling a fixed number of shares in a public offering and then use the proceeds to invest in bonds, stocks, or other assets. Since closed-end funds trade like stocks, their share prices can diverge from the per-share value of their assets.

When investor demand wanes, a fund’s shares can trade at a significant discount to net asset value. In theory, an investor could swoop in when that happens, buy up all of the fund’s shares, liquidate its assets, and collect the difference as profit.

Managers running closed-end funds that trade at steep discounts can use the opportunity to buy back some shares on the cheap. Selling some assets and buying back stock at a 15 percent discount, for example, could increase the net asset value of the remaining shares by a proportional amount. Doing that, in turn, could help bring the share price more in line with NAV.

Sometimes, though, fund companies try to avoid such remedies because they curb adviser fees. And that’s where Lipson’s strategy—which he will only say has netted double-digit average annual returns over the past two decades—comes into play.

Since 2004, when he started his activism, he’s fought with closed-end funds about 40 times, prodding them to repurchase shares or liquidate themselves or turn open-ended so investors can exit at a better price.

In his latest tussle, Lipson in August nominated himself and three other dissident directors to replace four members of the boards of two Deutsche Bank funds: Deutsche Multi-Market Income Trust and Deutsche Strategic Income Trust. He’s also seeking shareholder support to elect all directors annually, instead of in the funds’ existing staggered votes for three-year terms. “I tell all these companies I’m not going to do activism unless I can buy shares at a double-digit discount,” Lipson says. “And they know that. But they’re just so penny foolish. They let them go to big discounts, and they sit there in their fancy boardrooms rather than doing the right thing for shareholders.”

Oksana Poltavets, a spokeswoman for Deutsche Bank in New York, declined to comment.  Lipson has some company in closed-end fund activism. Saba Capital Management, which has plowed more than $800 million into closed-end funds in recent years, earlier this year battled with Deutsche High Income Trust. Bulldog Investors is another activist in the space.

For their part, nonactivist investors in closed-end funds tend to keep an eye on moves by the activists. “If we see Bulldog or someone like them getting some traction, we may pile in and help them get over the finish line,” says James Robinson, founder and chief executive officer of Robinson Capital Management, a Grosse Pointe Farms, Mich.-based firm that oversees $500 million.

Robinson runs open-end funds that invest in closed-end funds. He mostly stays away from the type of companies Lipson and other activists target, though. “Our experience for the most part is the runway is extremely long and the payoff is suspect,” he says. “We tend to focus more on the large companies that have good governance in place. They’re more focused on these smaller entities.”  Closed-end funds may be a relative backwater these days, but so was the bond market in the 1970s. In fact, Lipson says he shifted to fixed income at investment bank Kuhn Loeb simply because he didn’t want to deal with the hordes in equities. “I’ve always looked at underserved areas of the market,” he says. “The disadvantage is you have to do all the grunt labor yourself because there’s no existing databases or reference materials. The advantage is if you’re right, you don’t have competition.”

Lipson leveraged his background as a computer programmer—then a relatively rare skill—into fixed-income research. His firm raced bond king Salomon Brothers to create a comprehensive index for the U.S. bond market. When Lehman Brothers acquired Kuhn Loeb in 1977, Lipson’s research effort came along as part of the deal. As Lipson tells it, his index won out because he gave away his data for nothing. By contrast, Salomon Brothers wanted to protect its methodology and charge for it.

After Lehman Brothers fell during the financial crisis, Barclays, which bought the bankrupt New York-based firm’s investment banking business and other assets for $1.75 billion, had the benchmarks land in its lap.

Jack Malvey, who was Lehman’s chief global fixed-income strategist up through the firm’s demise, says he and his Lehman colleagues had fielded inquiries about selling the indexes for years. None became too serious, until the crisis forced their hands. “Barclays got a deal that was a tremendous home run,” Malvey says. “They didn’t have time to do any due diligence; it was basically part of the furniture of Lehman Brothers.”  Now mutual funds overseeing about $2.8 trillion of bonds—roughly 80 percent of assets in the fund category—benchmark themselves to various offshoots of Lipson’s creation, according to Morningstar. The Bloomberg Barclays U.S. Aggregate Index, in particular, is the most widely followed measure of fixed-income performance worldwide.

In December 2015, Barclays agreed to sell the indexes and related analytics to Bloomberg LP. The transaction was completed in August. (Bloomberg LP is the parent of Bloomberg News.)

Lipson finds it ironic that his index ended up in the hands of Bloomberg, because it was the advent of the eponymous terminals that hastened his exit from Wall Street. The computer background that gave him a leg up in creating the index was no longer ahead of the pack.

Lipson says he’s happy to have fled the Wall Street life, however, and insists there will always be a niche for his activist strategy. “I don’t know if it’s stupidity or greed or whatever, but the fund companies don’t respond—they just keep doing the same thing,” he says.

As for his index—the benchmark for the $100 trillion global bond market—Lipson doesn’t need to track it much for his day-to-day work. But he still keeps an eye on it. “I kind of have a long-term parental interest,” he says. “My child has gotten married and divorced several times since then, but I definitely follow it.” 

Chappatta covers government bonds at Bloomberg News in New York. 
To contact the author of this story: Brian Chappatta in New York at [email protected] To contact the editor responsible for this story: Jon Asmundsson at [email protected]

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