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Morningstar Closed-End Fund Research

CEF Weekly Article

Thoughts on Closed-End Funds from Industry Insiders

Highlights from this year’s Investment Company Institute conference. Steve Pikelny Fund Analyst steven.pikelny@morningstar.com +1 (312) 244-7361 Cara Esser Closed-End Fund Strategist cara.esser@morningstar.com +1 (312) 696-6395 Sumit Desai, CFA Fund Analyst sumit.desai@morningstar.com +1 (312) 696-6049

Depending on an investor’s level of interest in closed-end funds, this week’s Investment Company Institute’s (ICI’s) conference on CEFs can be pinned anywhere along the spectrum from boring to wonky. The conference isn’t geared towards individual investors and advisors as it is towards CEF industry personnel. This means that speakers generally focus less on market updates and selling their specific fund, and more on discussing CEF mechanics, new regulatory concerns, and challenges of sponsorship. The agenda certainly had its less exciting parts--the new, expanded definition of commodity pools under Dodd-Frank, for example, wasn’t as enthralling of a discussion as one might expect--but still offered some information that investors may find useful. In particular, discussions on the new issue market and secondary market support offer insight into the direction the industry is heading.

New Issuances CEF initial public offerings (IPOs) are a contentious issue. When a new fund is brought to market, underwriters take a sizable fee out of net assets (typically around 5%) for providing pre-issue services and secondary market support for a short time post launch. This causes CEFs to trade at premiums on day one. Investors are often skeptical of taking this deal (for good reason), making it difficult for firms to launch new funds. For CEF sponsors, this poses and obvious dilemma: Management fee revenues are tied directly to assets under management; fewer assets equal less revenue. Panelists offered a few perspectives on this dilemma. One panelist of particular note represented a prominent CEF underwriting firm. The key takeaway was that bringing new CEFs to market is incredibly competitive--the underwriting firm received roughly 800 new fund pitches over the last four years with only 16 slots for launches in each calendar year. That’s a 4% acceptance rate. Underwriters can afford to be picky. With such a small number of accepted pitches, investors may wonder how underwriters narrow the field. One of the primary selection criteria is that the fund sponsors be well-established. Underwriters need an extensive distribution network to help sell the new product. Large CEF families like Nuveen and BlackRock have an easier time raising assets than smaller firms like Bancroft or Foxby. In addition, larger fund sponsors typically have management teams with longer track records and are more likely to support the funds in the secondary market over the long-term after their launch. Secondary market dynamics also play a key role in selecting a new fund pitch to launch. Unsurprisingly, new CEFs need to pay competitive distributions. If a sponsor’s lineup is filled with low-distribution funds trading at discounts, a new fund can be a difficult ©2013 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied or redistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warranted to be accurate, complete, or timely. Certain information may be self-reported by the investment vehicle and not subject to independent verification. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use. Past performance is no guarantee of future results.


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sell. While one panel member rightfully pointed towards the importance of total return, income sells. Unfortunately, the question of whether income is overemphasized in new offerings is still open for discussion. A new fund’s strategy also needs make sense in the current market environment. Municipal ETFs and open-end funds, for example, experienced sharp outflows this year, and many CEFs saw discounts widen and premiums narrow in the second half of the year. Now is not an opportune time to launch a muni CEF--good luck convincing investors to pay a 5% premium when a plethora of discounted options already exist. . Alternatively, MLP and bank loan funds are now incredibly trendy, making it significantly easier to launch these strategies. In other words, income with low interest rate risk is what’s selling in the current market. The rub here is that timing is difficult. Fund firms often start the process months in advance which means that by the time an IPO is ready to launch, the market environment may no longer be favorable. The panel also discussed the growing popularity of liquid alternatives. Many investors want to diversify their portfolios, and alternative strategies offer returns with potentially low correlation to other asset classes. Meanwhile, many less-liquid alternative strategies are well-suited for the closed-end capital structure. But, a big concern for some panelists from a sales standpoint was complexity. It’s already difficult to explain CEFs to many financial advisors, so new funds should ideally have strategies that can be easily summed up in one or two sentences. One audience member (yours truly) suggested that new CEFs can only be brought to market, almost by definition, if the strategy is overvalued. After an awkward pause, the panel members admittedly took the blame. In all, it certainly brings to mind the industry adage: “closed-end funds IPOs aren’t bought; they’re sold.” But this panel wasn’t all bad news for investors. The conversation turned to alternative methods for raising capital in existing funds. In our opinion, these methods are often far preferable to launching new funds, especially if a similar strategy within a fund firm’s lineup already exists. In particular, shelf offerings have gained traction in recent years. Under this method, the fund files for the right to issues a certain amount of shares while it trades at a premium. If conducted correctly, this is accretive to existing shareholders, as the fund raises more in assets (the amount of the current share price) than they issue in net asset value. As we explain here, the offer can be conducted in two ways: The fund can issue the shares “overnight” (new shares are issued all at once after the market close) or “at the market” (new shares are dribbled into the market over longer periods of time). Shelf offerings are typically much cheaper than sponsoring an IPO, and allow funds greater flexibility. Secondary Market Support Post-IPO, it’s fairly easy for a fund sponsor to forget about their CEFs. After all, it has a permanent capital base on which they can continuously charge management fees without the fear of outflows. While some fund families let their responsibilities lapse, this is an obvious detriment to shareholders. Without action, CEFs can fall into disrepair, and subsequently trade at chronic discounts. The last two panels of the day focused on actions that sponsors can take to prevent this from happening.

©2013 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied or redistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warranted to be accurate, complete, or timely. Certain information may be self-reported by the investment vehicle and not subject to independent verification. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use. Past performance is no guarantee of future results.


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As a first line of defense, education in transparency plays a key role. This might include marketing funds even after the IPO, but can also include regularly disseminating detailed and accurate fund-specific information. In particular, the final panel (which contained several analysts) called for regular earnings- and distribution-related data. This is particularly important because CEFs often trade on their income-related qualities and accurate data is often confined to annual and semi-annual reports. Boards of directors also have plenty of tools at their disposal. Corporate actions and distribution policies, if used intelligently, can both narrow discounts and directly benefit longer-term shareholders through accretion in the process. In particular, monthly distribution payments, share buyback programs, returning capital at discounts, and merging similar funds were all offered by analysts as good tools. Firms like Nuveen, Aberdeen and First Trust are particularly active in this space. Overall, the conference covered a lot of ground. The industry has a major problem on its hands, in our opinion, when it comes to launching new funds. But, we’re glad to see that many important shareholder issues are on the radar of industry personnel.

©2013 Morningstar. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, “Morningstar”), (2) may not be copied or redistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warranted to be accurate, complete, or timely. Certain information may be self-reported by the investment vehicle and not subject to independent verification. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use. Past performance is no guarantee of future results.

Morningstar Highlights from ICI Conference  
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