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Investment Trust Update for the 20th September 2013.
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0|Investment Trust update
24|Winterflood
44|FTSE Small cap
67|Aberdeen
95|Threadneedle investments
Duration:
00:02:03
Recorded Date:
18 September 2013
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Transcript:
EVAN COOPER: Welcome, I’m Evan Cooper of Investment News and in today’s Masterclass we’ll be looking at closed-end funds. With me today in New York are three expert panellists. They are John Diorio, a Director of Product Management at BlackRock; Ken Fincher, Senior Vice President and Portfolio Manager at First Trust; and Anne Kritzmire, a Manager Director at Nuveen. Joining us in London is Piers Currie, Group Head of Brand and Closed End Fund Marketing at Aberdeen Asset Management.
Welcome everyone. Closed-end funds are an interesting yet relatively small and little understood segment of the investment universe. According to data from the Investment Company Institute the combined assets of the nation’s roughly 600 closed-end funds were $273.9bn at the end of June. By contrast, assets in open-ended mutual funds, the type of fund most familiar to investors, stood at $14trn at the end of July, while assets in exchange-traded funds were just over $1½trn.
If we return for a moment to Investing 101, we’ll recall that unlike open-end funds that continuously create shares to meet demand closed-end funds consist of a fixed number of shares that are bought and sold on an exchange. Since market supply and demand determine the price of a closed-end fund shares the share price may be higher or lower than the actual mid-asset value of the fund, and since these premiums and discounts are constantly changing the world of closed-end fund investing can be very interesting.
So what’s going on now in that world? For the answer to that question and others let’s turn to our panellists. Anne, give us your view of what’s happening in the closed-end fund world.
ANNE KRITZMIRE: Well the closed-end fund market’s been on a bit of a ride lately. As you said it’s a fairly small market; however last year there were a lot of new funds, a lot of new shares issued, about 12bn last year, and up until about May/June this year when everything else was firing on all eight cylinders in the rest of the markets closed-end funds raised about 13bn, so a lot of interest, because most of them are really designed for income and that’s really what people have been seeking these days. Then with everything else in the market kind of came to a halt around June, a few things sputtered, not any issuance at all in August and now we’re in September and things are trying to resurrect again.
EVAN COOPER: Okay, Ken, give your view of what’s going on.
KEN FINCHER: Sure, I think in addition to what Anne talked about we had to look at the secondary market for closed-end funds, which has really been on quite a tear for the past four plus years. People seeking income have always looked at the closed-end funds in the secondary markets. So a lot of the fixed income funds that were out there trading have moved from those discounts that people talk about in the secondary market to premiums, and we saw a lot of issuance in those areas where the funds had moved from the discounts to the premiums. As Anne mentioned, you’ve seen some sputtering here lately, because of a lot of the macroeconomic talk about the QE and the tapering of QE and/or the Fed when they’re going to start moving higher and short-term interest rates.
EVAN COOPER: John, what’s your take?
JOHN DIORIO: Yes, I would second Ken’s opinion, you know, what we’ve seen is that this year has been pretty dynamic. In the beginning of the year we were seeing a lot of clients looking for income, as Ken was talking about. With the tapering talk that started happening in May people started shifting and rising interest rates obviously can negatively affect bond funds that have some duration. The closed-end space has a lot of muni funds and taxable funds that do have some duration risk to them. And so that’s what we really saw was a lot of these funds that were trading at premiums, given the fact that they did have some duration on them, a lot of investors started to re-examine that risk within those portfolios and those funds started trading at discounts. I think we’ve got to the level here where those discounts have widened, yields have come up, and they’re starting to look pretty interesting.
PIERS CURRIE: Emerging market equity and bond funds were hard-hit at the end of the second quarter. That followed the comments by the Federal Reserve about a possible end to quantitative easing, and that in effect has dragged down the year to date returns. In discount terms, and this is according to Morningstar data, the average equity closed-end fund was selling at nearly 6% discount. Far from the average 1% discount that was happening at the close of the first quarter. At the start of the year, the average discount was in fact 7%, more or less in line with historic standards.
EVAN COOPER: Talk about income for a while, because that’s one of the lures, the attractions of closed-end funds, talk a little bit about why closed-end funds are good sources of income for investors looking for income, what differentiates them from other kinds of investments? So Anne, let’s talk about that a little bit.
ANNE KRITZMIRE: You know, as we’ve all said, most closed-end funds especially the ones issued over the last let’s call it 20 some years are really designed for income, and they’ve got a few more moving parts than your typical mutual fund. So not only do the shares not be issued after the launch there’s a few extra nuances if you will. Most closed-end funds use leverage, looking to seek a little bit extra income. They have a fairly intentional cash flow management process around there to try and take the overall total return and turn that into a regular stream of income whether it’s from a bond fund or even trying to take on a stock strategy and turn that into an appropriately smooth flow of cash flow throughout there. And then there is also that sort of opportunity where as you say when the price gets down the relative yield goes up and so people are looking for that too, but overall their designed to manage for cashflow, and that’s really how they’re traded and priced as well.
EVAN COOPER: John?
JOHN DIORIO: Yes, I mean to build off that point that Anne made I mean I think muni funds are a really interesting example. What we saw last year was munis obviously were very hot; a lot of these funds were trading at fairly large premiums. The underlying bonds that the closed-end funds own also trading at premiums as well and what we have seen since this time last year the muni curve interest rates in intermediate munis have moved about 150 basis points. So therefore these muni funds have sold off. And what that’s resulted in is now these funds are not trading at premiums any longer, they’re trading at discounts. The average discount in closed-end munis right now that we’re looking at are probably 5, 6%, there’s some that you’re finding 8, 9, 10% discounts.
What this is doing for closed-end muni funds that as Anne mentioned use leverage you’re getting an enhanced income component to that. So a lot of the closed-end fund munis in our lineup here at BlackRock they’re yielding over 7%. You put that in tax equivalent terms for the highest taxpayer that’s a pretty high quality portfolio that’s going to get you an 11% after tax yield. So again income is certainly out here, but as I mentioned earlier you’ve got to measure the income with that duration risk. A lot of these funds given the fact that they use leverage are going to have larger durations than maybe other mutual funds. So the average duration in a lot of these closed-end munis 7, 8 years, some of them up 10, 11 years. So the duration risk needs to be balanced with that income component.
EVAN COOPER: And all the income and that for the investor is tax free of the municipal bond?
JOHN DIORIO: That’s correct tax exempt for most of them, that’s absolutely correct.
ANNE KRITZMIRE: We talk a little bit about closed-end funds tend to offer more. They offer more investment strategies, they offer more income, they offer more opportunity, and they also come with more volatility too. So there’s never a free lunch. You need to be looking at the duration risk, you need to be looking at what else leverage does to you, but then what does leverage do for you and what is the rest of the design of the fund do for you too?
KEN FINCHER: And I think it’s important while we talk about closed-end funds are designed for income, as an investor you can’t solely focus on the income of a closed-end fund. I think more often than not people get themselves in trouble when they’re trying to buy the biggest discount or buy the biggest distribution rate or yield on their portfolio. There are times to own them and there are times where you need to pare your position, because they’ve been overbought in case sometimes when they’re trading their premiums or if you think from a macroeconomic side again like a bond that hey we’re in for some headwinds, we’re in some trouble, rates are going to be going up and as John mentioned when rates start to move up the prices start to move down, it’s the same type of dynamic you have there.
So don’t solely focus on the income, and I think sometimes you need to be tactical in closed-end funds versus strategic, and I think right now’s one of those times where the investor and the adviser need to take a close look at what they own, and make a determination, is that the best thing they need to own moving forward? These are perpetual remember.
EVAN COOPER: Let’s go back to the tactical versus strategic issue, if for an adviser that’s helping a client let’s say prepare for a time when they’re in retirement and sometimes the allocation of the portfolio is not static but it’s kind of stable. A closed-end fund in munis for example versus the muni bond fund could it be stable in the same way, saying okay I buy this and I keep it for three or four years, or do they have to look at it constantly to make sure the discount and the premiums are in sync? Like how does this compare to a conventional mutual fund in terms of the long-term applicability in a portfolio?
KEN FINCHER: You know, obviously every investor is different and every investor invests in closed-end funds will have a different reason to own their closed-end fund. Again, if you’re okay with the volatility that may come such as during periods like this you can walk through that period, you can do some dividend reinvestment if you aren’t retiring and you can try to reduce your cost basis. However, if principle preservation is really important then sometimes you may have to again pare that position in that closed-end fund, because you have a limited number of assets in retirement and whatever that net might be you might say I don’t want to risk a lot of that. So in a closed-end fund you can get some risk.
In a mutual fund again the net asset value and the price you get are sort of one in the same. So they’re going to move with the underlying value of that portfolio, and closed-end funds, we’ve all talked about it so far, we talked about discounts, where the price moves a lot more than the underlying net asset value and that tends to be where people get a little worried in terms of owning closed-end funds.
EVAN COOPER: Let’s go to people who have feet in both camps, whether a conventional mutual funds open-end or closed-end, what’s the difference? How should advisers and investors look at them differently?
ANNE KRITZMIRE: We certainly intervene, we sponsor both, and we don’t try to sell one against the other. Again we may have even a very similar portfolio strategy and approach in either an open-end format or the closed-end fund format, but the closed-end fund format is more often than not going to have leverage, so you’re going to have a little bit of a magnifier. It’s basically multiplying in a mathematic sense and if you’re a long term investor if you believe long markets are increasing, then you’d like to be magnifying something that’s long-term increasing. In the short term you’re going to magnify the volatility.
So, if you’re looking at a closed-end fund, if you’re looking for something like more income, you’re going to be looking for something that’s intentionally managed for income, and you’re going to be looking for something I think in some ways especially if you’re a long-term investor then you can ride out some of that volatility, because you will see it. On the open-end side, easier to understand, a lot more media coverage, a lot more resources around that, versus the small little nitchy thing here. We do find though that when we speak with advisers and they figure out sort of okay what are the things that I like and what are the things I need to be worried about or care about it’s like this secret. So they figure this out and say oh now I get it, now I see where I can use that.
JOHN DIORIO: Yes, I would agree with Anne. I think we think at BlackRock you can use them both together. For example as we’ve mentioned a lot of the closed-end munis that we have do have longer durations, but they do have that very attractive income. That’s something that if you think interest rates are going to increase, as we mentioned in the short term, you don’t want to have duration risk. So for example on the municipal side of our open-end lineup we have a short-term muni fund. We really don’t have any short-term muni closed-end funds, because the point you can’t get as much income.
So you can combine those two things. You can go out on duration on the closed-end side and look to pick up that really attractive yield that’s out there and maybe use a barbell approach with a municipal mutual fund that can be short in nature, it certainly can provide you with some duration protection on the other side. So we certainly think you have to use ETFs, mutual funds and closed-end funds in concert with each other.
EVAN COOPER: And Anne, you made the point about advisers looking at both and understanding, what should advisers do for their clients in terms of getting knowledgeable about this? What kind of help do you provide to them so that they know what’s going, because it is a somewhat obscure area of the investment world?
ANNE KRITZMIRE: It’s somewhat obscure. You know, people think it’s more complicated than it is. I’ve talked in the past about well if you need to understand the portfolio in a mutual fund you need to understand the portfolio and the capital structure and the distribution management and the trading. But it’s still four you can fit on one hand! So they need to learn those four topics and there’s information on various websites. All of us have websites that do that, all of us have sales and service people that help people understand that, and we’re actually working on a pretty exciting educational initiative also to try and help bring some of that to advisers too.
JOHN DIORIO: Evan, I think one of the big things that clients need to look at with closed-end funds, and this gets to Ken’s point a little bit, is the total return of them. What we find a lot is just because closed-end funds pay out significant portions of income or distributions, a lot of times that does not show up on a client’s statement, and what I mean by that is let’s say a fund is paying an 8 to 9% distribution yield, closed-end funds since their exchange traded even if you reinvest you may not see that 8, 9% distribution on your statement. So let’s say the fund is flat for the year, but pays out that 8, 9%, the client may think the fund’s actually down 8 or 9% when they’ve actually got that distribution yield.
So one of the real key things that we’ve been talking to clients about is make sure just like you would for a mutual fund or an ETF that you looked at these things on a total return basis, really important because they are such big income paying products.
KEN FINCHER: And I think it’s important to that point if you go back to 2009 when the market was a little bit in a tumult, because of the recession and the freezing up of the short end of the market, if you look at closed-end funds, muni closed-end funds is one example versus a benchmark, used to be the old Lehman Ag, it’s the Barclay’s Ag now, if you looked at their performance, muni closed-end funds on a share price, the national on a share price basis were up 40% plus, where the underlying benchmark such as a Barclay’s Ag, which is sort of the whole municipal bond world, was up about 9 or 10%.
So there’s a lot of opportunity in closed-end funds that you can take advantage of. Especially when you get into markets like we are right now where there’s some selloff, people don’t quite understanding it, and they’re throwing sort of the baby out with the bathwater, where people can say you know what there might be some opportunity here. And so if you do your homework I think that Anne pointed out if you do your homework and know those four things it can be a great opportunity for your investors.
PIERS CURRIE: Yes, closed-end funds merit being far better understood. They possess some structural advantages, as we’ve discussed, and I think misunderstandings about how discounts operate can be confusing on the surface, but that doesn’t mean that investment returns are any lower. In fact in performance terms again Fund Consultants LLC looked at the performance record over one and five years and found that closed-end funds outperformed in 19 out of the 30 equity sectors on a five-year basis. Fixed income closed-end funds outperformed in 20 out of 22 sectors on a five-year basis and we think this is mainly due of course to the structure for investment trusts closed-end funds can remain fully invested, and I think that investors and advisers will be well served by understanding more about the structure, fees and performance of these unique vehicles in future.
ANNE KRITZMIRE: One of the neat things also I think about the closed-end fund structure is because in those types of tumult we don’t have shareholders lining up at the door saying I need my money back. So the portfolio can stay invested. No, the muni bond market goes down, the value is going to go down, but you don’t have to sit there and sell into that falling market to raise a bunch of cash. So that structure actually helps insulate it a little better and if you’ve got the stomach to ride it out it can do very well. The other thing that can happen too is all of our portfolio managers can look out to that market and say gosh the rest of the market is selling, I have the opportunity to improve my portfolio, so there’s actually this sort of second level opportunity too.
EVAN COOPER: Has that gone?
ANNE KRITZMIRE: It absolutely does.
JOHN DIORIO: The last thing I would mention on this too is we’ve talked a lot about fixed income, there’s a lot of equity closed-end product out there as well. This is another area that it’s pretty misunderstood. A lot of these funds were launched in the 06/07 time period and therefore had a go through 08. So some of them didn’t perform as well just like any mutual fund didn’t perform in 08, but what happened with those funds is I think a lot of investors lost some confidence in those funds, so we at BlackRock have a lot of funds that actually write covered calls, so there are option strategies, so this is a nice bond alternative to add income, these funds are trading at 9, 10, 11% discounts, and what these option strategies do is they write away some of the upside but they provide some income.
So we get asked all the time what should I do with my money? The S&P’s up 15% here, I think the market’s going to be somewhat range bound, these option strategies are designed to do pretty well on those type of environments where you’re getting a little bit more volatility, we’re going to be in a range bound market, they can write away some of that upside, provide some income to clients and not have that duration risk maybe they have on the fixed income side.
EVAN COOPER: And how would advisers and their clients know that these funds can do that? Is it written someplace that says we can do these things?
JOHN DIORIO: Yes, that’s exactly right; it’s the investment objective of the fund. We all have websites as was mentioned so we disclose how much option writing we do in the product. We do disclose obviously what the objectives of the fund are, where they’re investing, whether it be in global equities or US equities, so that’s all pretty clearly delineated out on our website.
EVAN COOPER: And I mean is there a chance for portfolio managers to take some kind of crazy risk and do something that would be like outside the bounds of what’s supposed to be the-
JOHN DIORIO: No, I mean I think it’s actually the opposite with these option strategies that we’ve seen because it’s writing the covered calls what we find is we have a couple of funds that are very similar in the closed-end side and the managers also manage an open-end fund as well, and what we’ve seen actually is that the closed-end funds actually from a NAV standpoint as Ken mentioned the market price can be volatile as we all know, funds can go from premiums to discount, which adds that volatility a client that’s looking at their market price statement, but the actual NAV because you’re getting a little bit of protection from the covered call writing when the market goes down or stays flat these funds actually tend to do a little bit better. The negative side of it obviously as the market rips and goes up pretty strongly these funds are going to underperform.
So the way to look at these funds is if you really think the equity market’s going to go up strongly you want to be buying mutual funds in ETFs. If you think the market’s going to be flat you want a combination of all of them and if you think the market’s going to be down, the closed-end fund’s going to go down along with it, but it’s also going to provide a little bit of buffer, because you’re not going to be down as much because you’re writing this option strategy.
KEN FINCHER: And I think it’s important to remember closed-end fund is just a structure okay and I think people get lost in the whole income premium and discount and closed-end fund is in the structure and into John’s point it can invest in anything, you know, whether we’re talking municipal bonds or we’re doing option override strategies and equities. So it’s important for people to go when they’re getting into a closed-end fund as you mentioned, look at the objective of the fund, what is the fund investing in, what do they hope to come out with that investment objective, how in different markets are funds going to perform based on what it’s investing in on the underlying. So I think that’s very important for people to understand.
EVAN COOPER: And what are some of the more interesting strategies or some that people might not be aware of that are available in closed-end funds? You know, you said writing covered calls is one thing that they do, but what other kinds of things do they do that people might not know about?
KEN FINCHER: Yes, I think right now I mean where you’re getting a lot of interest and you’ve not only seen it in the IPO market, but in the secondary market is the senior loan funds, those are fixed income, but they’re floating rate. So unlike a bond where you have a fixed coupon, these will float with Libor and they typically have a 60 to 90 day reset. That’s been very hot with people who are trying to manage duration risk. I think John’s talked about that, people who are saying hey, look I think rates are going to go up, how do I participate when rates go up? And a lot of people have looked at the senior loan asset class as a way to participate and to hedge some duration risk that they may have in the muni portfolio or their taxable fixed income portfolios, such as high yield bonds or investment grade corporates.
ANNE KRITZMIRE: And we’re seeing a lot of that, that actually was senior loans have been in closed-end funds for a long time, they’re in open-end funds as well, but certainly ten years ago they were less liquid, and that’s where it made a lot more sense to see it in the closed-end fund format and take advantage of that floating nature and the dynamics of how it’s going to behave in different interest rate markets. The other thing that you’ll see a lot also on the senior loan side is because the actual income from the portfolio’s going to rise as short-term rates tend to rise and it’s leveraged that spread actually can march on through time. So it makes a lot of sense to be able to apply leverage to that strategy.
So sometimes you’ll see things in both open and closed-end, you may see it earlier in closed-end or in different nuance, because that closed nature actually facilitates that. Several years ago we saw with the refinancing and the government, the public private partnership programme, so you saw PPIP and distressed mortgage backed securities in closed-ends. Again when you’re not as concerned about liquidity that’s a really natural place to try and see closed-end first, but then any other strategy you see a mutual fund investing and can also be packaged in a closed-end fund and managed for the income.
EVAN COOPER: Piers, you’ve talked a lot about using closed-end funds for domestic equities and fixed income, what about in emerging markets and international funds for US investors?
PIERS CURRIE: Yes, emerging market closed-end funds have experienced a volatile year, despite this our fund managers believe the pullback has been healthy for the most part as share prices throughout the emerging markets rose despite a slowdown in corporate profits. But there are concerns. China faces slowing growth and a banking crisis, India is similarly in a problem of its own making with rising prices and a collapse in government revenues, but at Aberdeen we believe the selloff represents buying opportunities across our funds and our fund managers are able to identify potential opportunities at attractive valuations now.
EVAN COOPER: How much leverage is in a fund? What can they do? Are they limited by any kind of rules as to how much leverage they can use? I mean in the last five years leverage has kind of gotten not such a favourable connotation, so what are the limits in this?
KEN FINCHER: Sure, go ahead.
ANNE KRITZMIRE: Okay, yes. Okay, so closed-end funds are there, they’re regulated by the ‘40 Act, just like open-end funds, are and the ‘40 Act limits the amount of leverage to either 50% or 33% depending on what flavour you use. If you leverage by borrowing debt like bank loans or lines of credit it’s 33%. If you flip that around advisers understand this, but sometimes the investors really like hearing it this way if that was your home mortgage that says you have to have 67% equity at all times. So it is leveraged, but it’s not a 50 times sort of CLO thing. Debt leverage is limited to 50%. There are other forms not regulated by the ‘40 Act where you invest in a leveraged instrument in the portfolio. Those aren’t regulated by the ‘40 Act, but generally your prospectus and your fund board of directors is going to be watching that and there will be a limit there too.
JOHN DIORIO: One of the most misunderstood things about leverage too is people see rates going up, we’ve talked a lot about rates going up so far today. The borrowing cost on the closed-end leverage is based off of very short-term rates. As we all know our view at BlackRock is the Fed’s going to be pent here for a bit and short-term rates probably aren’t going to move for some time. And so with that actually even though you’ve had longer term and medium-term interest rates moving up, what we’ve seen actually is the borrowing cost on our funds really hasn’t moved at all, whether it be a muni fund or a taxable fund. So the steepness of the curve is something that you really want to pay attention to.
Obviously if you can borrow something at a very cheap rate and now you’re actually going out and investing further out on the curve which is steeper that’s a really good environment for closed-end funds, and so that’s been something that’s been a pretty positive dynamic here. It gets lost in the picture just because interest rates in general are going up, so a lot of these bond funds that have duration unfortunately have gone down, but the extension and the steepness of the yield curve is actually in the long term could be a good thing for closed-end funds.
EVAN COOPER: And who does the borrowing, is it BlackRock who does the borrowing? I mean you borrow much cheaper than individual investor can borrow.
JOHN DIORIO: The funds.
EVAN COOPER: The fund.
JOHN DIORIO: So the funds take those assets and borrow on behalf of the shareholders who are in the fund.
EVAN COOPER: So that’s pretty inexpensive for them to borrow.
JOHN DIORIO: It is, it’s fairly inexpensive and I said based on a very short-term interest rate, so borrowing cost right now very cheap for historical standards.
EVAN COOPER: I mean Anne mentioned this, I’d like to get everybody’s input on it, when the fund invests in a particular vehicle and then that sort of goes out of favour, or time to change, the fund doesn’t stop? I mean these are perpetual funds, so they just change what they own?
ANNE KRITZMIRE: You know, as we talked, they all have an investment objective, an investment strategy and that’s in the prospectus. So sometimes they’re pretty much going to stick with that strategy. They may on the tactical side look and say all right within these boundaries I’m going to shift here versus there, if you’ve got a fund that’s allowed to invest a cost capital structure and right now maybe saying okay I’m going to be pulling back a little bit from debt, because the debt or bonds are going to be getting distressed a little bit in the near term and then move more towards common equity. If the fund has permitted to do that it will do that. If it really feels like it’s just bent or broken then the fund manager can look and say all right in the best interests of the shareholders put it to the fund board and say we think we ought to make a change, the fund board recommends it and the shareholders may or may not need to vote on it depending on how it’s been written in.
KEN FINCHER: I think it’s important to remember that most closed-end funds are actively managed portfolios. So we’ve all talked about on the fixed income side duration risk, those managers had the ability to pull that in a little bit. I think now with the new forms of leverage that are out there it’s much more flexible for the manager to actually delever a little bit from time to time if they see that theirs is risk on the short end in the curve or there’s risk because of higher interest rates. It’s important to remember though that leverage will accentuate gains and accentuate losses. So if the market’s going against you or it’s going out of favour and you’re seeing prices drop let’s say on bonds it can accentuate and it can pull the losses a lot further down than it would have if you just had an unleveraged portfolio, but vice versa. In a market like we’re just coming out of where for four plus years it’s been nothing sort of but headed north these funds have shown tremendous total returns, why, because leverage actually worked in their favour.
ANNE KRITZMIRE: We actually have a white paper that we did, we put it through to a model on that one, and that’s again where being a long-term shareholder can benefit you. It was a model using some indexes and looking to say what was the difference in a muni bond portfolio with and without leverage? And if you’re looking in a 12-month timeframe the difference could range from hurting you by another 4½% to helping you by 7%, so depending on that volatility. As you move out towards five years it almost always helps you, but the average help, the average benefit was another 200 basis points or so. And that average stays pretty much similar through time, but as you get to that longer timeframe you lose the up, you lose the down and again it’s a hypothetical but in that model it helps, it always helps.
EVAN COOPER: Let’s go to the issue of costs, there are benefits, there are things you have to watch with closed-end funds, how do they compare for the investor cost-wise to an open-end fund? What are you paying for and what do you get, what’s the cost of all this?
KEN FINCHER: Sure, I mean they’re fairly similar to an open-end fund; I mean they have a management fee and an expense ratio. Open-end funds have ongoing distribution fees, closed-end funds don’t. So it all depends obviously what the underlying asset is. Some assets may have higher management fees than others, but from a cost perspective it’s often fairly similar that the one thing that we get asked a lot about is sometimes closed-end funds look like they have higher cost than open-end funds, and that’s because depending upon what type of leverage you use sometimes you’ll see that leverage cost put into the prospectus if you will.
So obviously there’s a cost as we talked about associated with borrowing and that cost could be shown as obviously an expense, but obviously you’re hopefully getting a nice benefit for that. So make sure when you’re looking at the cost of closed-end funds that if there’s an interest expense in that you sort of net that out to make it an apples to apples comparison.
PIERS CURRIE: Because a number of shares are fixed in a closed-end fund there aren’t the operating fund costs involved with distributing, issuing and redeeming shares, so closed-end funds typically have lower expense ratios than their open-ended counterparts. To verify this we asked an independent firm Fund Consultants LLC, they look at closed-end fund analysis using Morningstar data, and we asked them to analyse the difference between open-ended funds and closed-ended funds in terms of expense ratios, and they found that expense ratios were around 1.6% for equity closed-end funds compared to 3% for open-ended mutual funds. As they dug more deeply they found in equity funds and emerging markets that difference was even more acute. Their research showed that emerging market closed-end funds had an average expense ratio of 1.7 compared to 3% of emerging market open-ended funds, and that’s quite a significant differential.
KEN FINCHER: I’d like to take a different tact, let’s look at opportunity cost for a closed-end fund versus an open-end fund. Obviously we know in open-end funds and ETFs money consistently comes in, so the manager is always having to put money to work that’s in a really good market. The beautiful thing about the closed-end fund is you have a fixed asset base. So they can be fully invested at all times. So they don’t actually have to move their portfolio as let’s say we’re getting into a rally in municipal bonds, they’re not having to invest in coupons that are fives, fours, threes based on where the market’s going. So the opportunity cost is there’s less drag on a closed-end fund, because it is a fixed portfolio, versus a mutual fund where everyone says hey I need to be in there now and that manager is just inundated with money to put to work and a lot of times you start to see performance suffer a little and you actually see the income start to come down. You don’t have that same problem in a closed-end fund.
EVAN COOPER: Anne, any other comments about the cost?
ANNE KRITZMIRE: No, I think the only other thing to think about the cost is because these are listed vehicles that there is the trading cost. So if you the investor or the adviser are active then you’re going to be adding to your costs just in basic trading costs and, you know, different structures, different share classes on the open-end side have different entry and exit fees on there as well, but as Jonathan said at the portfolio management level they’re very similar.
EVAN COOPER: And one of the issues that comes up perennially is the idea with trading at discounts and premiums when to buy the funds, when there are discounts, when a premium’s at the IPO time and when it’s offered then does it go down, does it go up? What about that, that whole issue of trading at discounts when to buy, when it’s dissipated buy it at a premium, because some people say why should I pay a $1.10 for something that’s worth $1 if I could wait and get it for 90¢. You know, what’s the response to that?
ANNE KRITZMIRE: Well you should always buy low and sell high. So even if you buy it at $1.10 and sell it at $4 that’s good.
KEN FINCHER: I mean it’s deeper than premium and discount. I think too many people get caught up on yield and premium and discount on the closed-end fund space, and you really have to look through to what is the underlying objective of the fund, what is the macro and economic environment that we’re in, and is there opportunity? Case in point more recently last few years has been MLP funds, master limited partnership funds, which are involved a lot in oil and gas production and oil and gas distribution, whatever it might be, whatever that fund’s invested in those funds have traded at premiums to net asset value, but the premiums have been persistent and the funds have continued to move higher. Now that premium may go from 4 to 5 to 10% back down to 4%, but they have been a good investment.
Now that’s just one example, but you’ve got to look deeper than just the premium discount. Too many people get caught up and get themselves in trouble when they only look at the ‘I’m going to buy the biggest discount or the biggest yield’ you really need to look a lot deeper. What’s the objective of the fund, who’s the manager running the fund, and do I think there’s a catalyst for that fund either to move higher or for them to close that discount to net asset value.
ANNE KRITZMIRE: I would echo that, you know, if you’ve got a fund that’s paying out a 9% distribution rate, oh yeah let’s turn cartwheels, well is it earning in? No, and do I think that strategy has legs into the future or in my investment horizon? So you do need to look and say all right, okay, what am I actually buying? Most people are trying to buy the cash flow, so then is it actually generating something that’s going to cover that cash flow over timeframe? The premium discount thing also some funds trade at persistent premiums, it’s a supply and demand game, and if there is persistent demand and the supply is either not able to or just not permitted to go and meet that you’re going to see something that trades at a slight premium to the net asset value that’s still obviously valuable to the people buying.
EVAN COOPER: And you were talking about master limited partnerships, what’s the advantage of being in a closed-end fund for that as opposed to buying the master limited partnership directly?
KEN FINCHER: Well the number one advantage is for the people who buy those is because if you’re in a C corp which means they can invest more than 25% in MLPs then there’s no K-1s, so for a lot of people they just don’t like the K-1s, there’s a lot of paperwork to do with their taxes and so that’s one of the big advantages for folks who are those types of investors.
ANNE KRITZMIRE: The other thing you’ll see is you can put a little leverage on as we’ve talked about, because the closed-end structure as a C corp allows you to apply again a modest amount of leverage and enjoy even more the benefit of a MLP.
EVAN COOPER: Yes, and like open-end funds during the year the tax I guess consequences of owning a closed-end fund do you get taxed on the gains internally in the same way you would with an open-end fund? Is it the same kind of tax remit?
JOHN DIORIO: You would, so you could have a tax, obviously a lot of funds pay monthly or quarterly distributions similar to what you would get in an open-end fund, if a fund is overearning it may have to distribute also at year end. You know, one of the interesting things on closed-ends is that you do though typically see that any tax loss selling, which I think is a little bit different than an open-end fund, sometimes what we see is some seasonality in closed-end funds where if a fund is maybe down you get some tax loss selling and as kind of Anne had mentioned everything is supply and demand, and so just a little bit of tax loss selling sometimes can make some pretty good opportunity just given the fact that people are selling a fund for no other reason, not that it’s broke or that it doesn’t have a good investment outlook, but just to go ahead and obviously take a tax loss for tax purposes.
So what we’ve seen in the past is periods of time like late October into November and December sometimes you see those closed-end fund discounts widened out only for one reason, that’s for this tax loss selling, which is a pretty interesting phenomenon that goes on.
KEN FINCHER: And that adds to the opportunity of being a closed-end fund investor truly because it is more retail based investment or investor based, there’s not a lot of institutions involved, and I think to John’s point is you get inefficiencies during certain seasons that as an investor you can go out and take advantage of and you can actually get some outsized returns versus a traditional mutual fund or a traditional ETF.
EVAN COOPER: So October 20th you buy them and January 15th you sell them, is that the-
KEN FINCHER: Not giving advice.
EVAN COOPER: We’ll just watch out for that.
KEN FINCHER: You have to watch out for the seasonality.
ANNE KRITZMIRE: No guarantee, but you might look.
KEN FINCHER: That’s right.
EVAN COOPER: Let’s talk about, we talked a little bit about investors having different objectives of course, but for a retirement income where does this fit in? If somebody was doing a portfolio an adviser for their client to what degree do you think closed-end funds might fit? Then again not that they’re all the same, the fixed income ones and equity obviously, but where does it fit? Like where should an adviser think of these as possibilities in the total spectrum of their investment portfolio decision making?
PIERS CURRIE: Sources of income can include interest and dividend income from the securities held in the portfolio and capital gains, but may also include a return of investors’ capital. Therefore a closed-end fund investor or adviser should not draw conclusions about performance from the amount of a fund’s current distribution levels. It may need to look deeper into the fund’s distribution policy. Another bit that’s sometimes forgotten is that equity funds can generate income as well as bond funds by the way.
One attractive element of closed-end funds by their structure is on undistributed income, which has benefits too, so closed-end managers can sometimes hold onto income and capital gains and although the funds pay taxes on such assets these undistributed net investment income can help to grow the asset base and potentially smooth income payments during volatile market conditions and this is sort of one additional benefit of the closed-end structure.
JOHN DIORIO: I mean again we think closed-end funds are a great vehicle for income and obviously depends on every client’s different, so it’s a tough question to answer just given the fact that don’t know whatever client’s risk tolerance is and as we mentioned over the long term closed-end funds have been great for all the reasons that we’ve outlined. But what we find is a lot of clients like to live off their income and so a lot of these funds do try to have consistent payouts. You know, one of the things that we try to do at BlackRock is when we set a distribution we certainly have to adjust it from time to time, we do not want to be adjusting that distribution month after month; in other words we don’t want that distribution rate changing.
So we try to keep that distribution as stable as possible, because we do realise clients may live off that income or account on that income. So for clients that are on a fixed income and want to get a payout of 6, 7, 8%, whatever percent it is, they have to definitely look at it and see what the risk is of it, but it’s a nice way to go ahead and have a steady income stream come into your portfolios.
KEN FINCHER: I mean I would echo what Jonathan said every client is different, so from a compliance input you’ve got to look at every client differently and whether or not closed-end funds work, I think in my opinion I think they deserve to be a piece of someone’s portfolio and again based on their risk tolerances you’ve got to really look at, you know, are they willing to put some of their retirement monies at risk? And because these are perpetual listed traded vehicles. Just because you get in at let’s say $14 doesn’t mean you’re going to get out at $14. They don’t come to an end like a municipal bond might come to an end, so there’s additional risk there. But I think they are a little bit more income oriented than some other traditional ‘40 Act type of investments. So I think every investor has to look at what’s their risk tolerance, how much principle are they willing to put at risk in regards to a closed-end fund structure?
ANNE KRITZMIRE: I would agree. I think most and some of the analysts at the major wirehouses have also talked about this. I think everybody but maybe the absolute most conservative investor ought to really take a look at closed-end funds either for you’re looking for more income, more cash flow or you’re looking to diversify because the structure actually allows you access to a couple of other strategies that might zig when the rest of cash flow and income portfolio is zagging. So I think everybody ought to be taking a look at a little bit of that, understanding it’s got that more potential, it’s got the more cash flow potential, which is a goodness in most people’s eyes, but it’s not a guarantee.
So if you absolutely need a floor and a guarantee this is not the vehicle for you. That said I think we’ve all made the point in different ways the price might be a lot more volatile than the actual cash flow and as fund sponsors we work hard to try and make that cash flow either as smooth as possible or as smoothly changing.
EVAN COOPER: And you say they fluctuate, I mean that’s the cheque that they get every quarter or?
ANNE KRITZMIRE: Month or quarter.
EVAN COOPER: So the cheque doesn’t change, of course the value of what the investment-
JOHN DIORIO: The value of the investment can change and the distribution can change right if a fund is doing well there might be the potential to increase a distribution; if it’s doing poorly or the market changes there may be the need to go ahead and decrease it. We don’t want to over-distribute and have clients have depreciation in their investment to some extent right, so that can change, but I think what we’re trying to say is we get that people count on that and so we try to keep it as stable as possible.
ANNE KRITZMIRE: To Jonathan I just wanted to add one, because Ken’s made the point also, you know, look beyond the distribution. You really need to look beyond the distribution, because Jonathan was saying an attractive distribution that is coming at the expense of the fund’s actual capital over time is not a good idea, so again you need to look that one step further and say all right is this getting earned?
EVAN COOPER: But what do you see now that if indeed interest rates will tend to rise and who knows everybody thinks they will, but it’s confounded us in the past, what other kinds of investments or strategies do you see coming in closed-end funds? What do you think is on the horizon that investors could look forward to?
JOHN DIORIO: One of the things that Anne talked a little bit about in the beginning of this there was a lot of funds that were launched in the beginning of the year, and we talked a little bit also about bank loan floating rate funds, a big product that came in the beginning of the year was some multi-sector fixed income funds, and these funds have the ability to go into things like bank loans and other floating rate product, but can also go into other different sectors. So the key to these funds was most of them tried to keep their duration low, but weren’t sort of just narrowed in on one asset class. And so that’s something that we launched one of these in February. We think it’s good for two reasons.
One we can keep the duration of the portfolio low, but number two in this more volatile fixed income market that we’re likely going to have to the point we’ve made active management’s really going to be key, and so things may go in and out of favour more quickly. So if you can only invest in bank loans, you can only invest in high yield, we’re tying our portfolio manager’s hands a little bit. So we want to have the flexibility and so this product that we launch for example it was going into non-agency mortgages, we have a positive view of the housing market, it was going into bank loans, which have a very low duration, it was going into high yield, so it kind of gave you what we thought our best ideas were and will continue to give you our best ideas. So this is something that’s been relatively new within the closed-end space over the last year or so.
KEN FINCHER: And obviously you’re seeing more of it from real star managers out there, think of sort of the everyday household names, not only the BlackRocks, but you’re getting the PIMCOs and you’re getting even non-traditional closed-end fund players who are getting involved in closed-end funds because they have those capabilities to capture the asset base and they like flexibility in their investment thesis. So they’re able to go out there and invest hey well here’s where we think the opportunity is or if the market goes this way here’s where we can go there too. So that portfolio manager is getting a lot more creative and the funds are going to be sort of more of these all-season funds that hopefully through different market turns that the underlying net asset value.
Now we can’t say what’s going to happen with the share price, but the underlying net asset value’s going to perform where they can defend that portfolio so that when it’s time to actually make some more money that they have money to work with in that net asset value.
ANNE KRITZMIRE: We think, as both Ken and John have talked about, a lot of the most recent launches have been really in the fixed income space except for the MLP space, which has been very, very high. So I think we’re talking about it on the open-end side, we’re going to probably see it on the closed-end side, which is probably looking to the future a little more issuance in the equity side, we haven’t seen a lot of that lately since probably the crisis. We saw a lot in 05, 06 and 07, but that’s probably going to be on the horizon also as people look to say all right how do we do that? That becomes a little more counterintuitive, how do you get cash flow out of an equity that’s only yielding 2% on the S&P 500, and that’s where the structure does a really good job, if you’re managing the total return to be able to say the dividend plus the total return and deliver that off to a shareholder.
EVAN COOPER: But these kind of go anywhere kind of strategies which seem somewhat like hedge fund like in a certain way is that I fear in saying that, because they have greater flexibility to the managers to do lots of different things right?
JOHN DIORIO: I wouldn’t call them hedge funds, again hedge funds are a structure they could use potentially more leverage, they go into things that might not be sort of what we would call securities. Most of the product that we have within these multi-sector funds have a CUSIP or are securitised. Certainly we think of an advantage of the closed-end wrapper is that you can buy more illiquid assets. For example we wouldn’t want to hold too much non-agency mortgages in a mutual fund portfolio, we have more comfort holding larger amounts in a closed-end, because we know we’re not going to have the inflows and the outflows, so they can certainly take advantage just like a hedge fund of maybe the structure that we think closed-ends provide, but I certainly don’t view them as a hedge fund type investment.
ANNE KRITZMIRE: If you think about it also because they’re regulated in the ‘40 Act investments, (a) you’re going to get all the financial reportings, so there’s a whole lot of transparency that hedge fund wouldn’t normally afford you. You’ve also got the visibility during the trading day in terms of what price are you willing to pay for this.
KEN FINCHER: Well and also these things are all done through IPOs, so they all have to go through the investment banks. So the investment banks are going to do their due diligence and they’re going to knock out certain things that they say we can’t value that, we don’t feel comfortable with that or we’re going to limit what you can do there. So these things are all done typically through an IPO. So you really get those governors put on during the IPO process.
JOHN DIORIO: There’s unfortunately a lot of confusion about these funds just because of the timing. So as we talked about a lot of these funds were designed to not take on a ton of duration risk. As we know May and June was sort of a pretty interesting time in the fixed income markets, while interest rates were going up obviously credit spreads also came out a little bit, so not only did you have things that were sensitive to interest rate selloff, but you had credit sensitive investment selloff. So I think investors right now with all these multi-sector funds for example the one that we launched is trading at a 10% discount, it didn’t go down in May and June because of the duration and that’s what everybody’s worried about, it went down because things like high yield sold off because people were going into this sort of risk-off environment giving sort of the talk out of the Fed. So we think once these things seasoned a bit people get a chance to really understand them a little bit better they should hopefully trade a bit better.
EVAN COOPER: Obviously for investors who were looking at open-end funds there are a multitude of ways to look at how their fund is doing whether they got stars in Morningstar. With closed-end funds it’s a little different other than they look at the price obviously, but is there a way to measure one closed-end fund against another or say how’s mine doing versus the universe? How do people look at that?
ANNE KRITZMIRE: There’s a little of, you know, why did you buy it? Nuveen sponsors a site called CEF Connect where we try and make that information available and it’s not just Nuveen funds, it’s the entire marketplace where you can look and say well alright why did it buy it? How does this distribution rate stack up against others that I could have looked at? How is the performance relative and they all do have benchmarks. It could be a very standard broad benchmark like the S&P 500 or it could be something a little more customised to something like the MLP space or the reap space or the mortgage backed security space.
So there definitely is a lot of scrutiny. These all have fund boards also, and the fund boards at least ours is looking at this every quarter saying all right how is this performance against what we expected, and then how is it against what the rest of the peers say.
JOHN DIORIO: They also do have Morningstar and Lipper categories, so similar to open-end funds they are looked at by Morningstar and Lipper.
KEN FINCHER: And I think it’s important look at the performance on a net asset value basis. That’s truly how the portfolio is performing, it’s not the share price, and fund sponsors can do different things to help their share price performance versus net asset value. And they can do different things to net asset value performance, but if you see outliers there you’ve got to start questioning why is there an outlier, why is that NAV so much better than the rest of the group’s NAV? So there may be some what they call effective leverage. Anne talked on it earlier, talked about doing things inside the portfolio that the manager can do to actually lever up, which isn’t counted towards their ‘40 Act leverage, but it helps them perform different ways in different markets.
EVAN COOPER: And for advisers what’s a takeaway for them? What should they be looking at? What should they be thinking about if this is something that they know is there, but maybe they haven’t spent a lot of time looking at the closed-end market, what would your take away be for them? What should they do to become familiar or what should they look at or how should they view closed-end funds?
ANNE KRITZMIRE: I think the first thing would be we’ve all made the emphasis that they should be being used as a component of an income portfolio, so we’re looking for cashflow. It’s the opportunity to diversify a portfolio, so then they should be looking at that saying all right what kind of portfolio is this; what do the investors need; am I in tax exempt or am I in taxable world; what else is it living next to; so what else am I going to be trying to diversify against that; what kind of cash flow am I looking for; what price am I willing to pay? Again you want to evaluate the performance on the NAV. I completely agree with Ken’s statement there, but it’d be nice if I could buy it on the market price in the fast-moving market price if I’m looking at everybody else is walking away from it, the price is going down. If there’s nothing intrinsically unstrange with the NAV and that strategy and the performance I’d like to be a buyer there.
KEN FINCHER: I would flip-flop what Anne said, because I would not look at income first, I think it gets people in too much trouble when they focus on the income of a closed-end fund. Remember closed-end fund is just a wrapper, it’s just some more to a mutual fund, some more to an ETF. It’s just what you’re putting inside there. So you have to look at what is my expectation of what’s inside that portfolio; what’s the objective of the fund; who’s running that fund? Okay, now what I have hey if I want to have an allocation to senior loans or emerging market that I know what’s in that portfolio, sort of what’s my outlook for that? So do I think that’s a point where we’re going to see some upside potential? From there look income is a by-product on most closed-end funds, so you can hit any closed-end fund, so if you want income sort of you could throw a dart and find income in a closed-end fund world. You have to look at the underlying first, don’t focus so much on yield or income or even discount or premium, focus more on who the manager is, how they’ve performed, how’s that net asset value performed and why should I invest with that particular sponsor?
EVAN COOPER: And afterwards if you like all that and if it’s selling at a discount it’s even better right?
KEN FINCHER: It’s gravy.
JOHN DIORIO: No, I would agree and that I’ll go back to the original point I made, there’s a lot of misperceptions on closed-ends because of this income component. A lot of times they get looked at again on just price appreciation. So I can’t tell you how many times we’ve seen a chart where somebody charts our closed-end fund versus a benchmark and they’re just showing price, but as we’ve talked about you’ve gotten this nice distribution for the last five years, so you’ve got to look at it on total return. And I think for t