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Transparency: How Leveraged Is Your Closed-End Fund?

Not all types of leverage are reported equally.

Mike Taggart, 06/15/2010

Transparency is a word used a lot with closed-end funds. Investors complain that there isn't enough of it. They want more information on how their CEFs operate and why discounts persist. Fund families with reputations for being extremely transparent and instituting best practices agonize over how to provide even more information to investors. They want investors to know what's going on, because they believe more information makes for better market efficiency and lower discounts. Alas, most funds are behind the curve, uttering a desire for transparency but doing little to shine light on their own funds.

As a CEF investor and enthusiast, I am quite shocked to see how little information is actually disclosed in CEF regulatory filings. I get a sense of what the imminent father of value investing, Benjamin Graham, must have felt when trying to analyze companies in the 1920s and '30s. Not that the funds are doing anything unlawful--I'm reasonably sure they are following the rules. They report what they are required, and those fund families at the vanguard of investor friendliness disclose a good deal more. The issue seems to be that regulatory requirements for disclosure fall short of the requirements for even small publicly traded companies. Consider just one example: Every company is required to provide in each annual report two years' worth of balance-sheet items; CEFs are required to divulge just one year. As an analyst, it's not a big deal for me to construct a multiyear analytical model for each fund, but this would be a pain for investors with other time commitments. Connecting the dots across the financial statements is also not a simple task, but the annual filings provide little guidance. In any event, transparent is not a word I would use to describe that most basic of CEF documents, the annual report. And with no regulatory mandate for more disclosure, it falls on fund companies to determine what extra information they will provide.

Types of Leverage and Leverage Reporting
Under the Investment Company Act of 1940 ('40 Act), closed-end funds are allowed to employ financial leverage. The '40 Act forbids CEFs from issuing any security senior in the capital structure to common stock unless that security represents indebtedness or preferred shares that meet strict mandated guidelines and provisions. This was meant to protect investors from shady capital structures that had permeated similar funds in earlier decades. Failure to comply with the Act's provisions brings about severe repercussions: In the downturn of 2008, a few funds found themselves with inadequate coverage ratios and were forced to liquidate investments and suspend distributions.

Because the laws regarding indebtedness and preferred shares in CEFs are straightforward and failure to comply is so severe, reporting of '40 Act leverage is rather standardized throughout the industry. If a fund has debt or preferred shares outstanding, it will make mention of the fact in its regulatory filings. If it has halfway-decent investor stewardship and transparency, you should be able to find such information on its website within a few minutes. On Morningstar.com, you will find the '40 Act leverage ratio prominently displayed on a CEF's Quote page. Overall, funds tend to be very transparent with '40 Act leverage. There is little, if any, mystery as to its existence.

Non-'40 Act leverage, however, is a different beast. Whereas the provisions for leverage within the '40 Act were meant to safeguard the integrity of a fund's capital structure, non-'40 Act leverage is unrelated to the capital structure. It arises, instead, from the fund's portfolio of investments. Tender option bonds, reverse repurchase agreements, and securities lending obligations are types of non-'40 Act leverage typically used within portfolios. Largely because they are not officially regulated under the '40 Act, there is no standardization in presenting the leverage effects. Indeed, investors would often be hard-pressed to find information regarding such leverage without proper guidance.

I hesitate to use a fund as an example, but I will. After all, of the 619 CEFs that we track, 446 utilize some sort of financial leverage, 290 of these utilize non-'40 Act leverage, and 61 rely solely on non-'40 Act leverage. To pull one out of the pack for an example seems harsh. Consider, though, the China Fund CHN. This 5-star rated fund recently had a change in its investment manager, two good reasons to offer it up as an example. An investor would not find any information on the fund's website suggesting the use of leverage. Yet, at the end of its last fiscal year, the fund had a rather mild 10% leverage ratio. Magnitude isn't the point; disclosure is. Turning to the annual report, an interested investor would come up with no results if she searched for the term "leverage." Reading the fund's performance review from its (former) managers, she would see that "the fund's outperformance came as most of its key themes worked well over the year." Likely true, except they forgot--to be generous--to mention the positive effects of the leverage. Not unless she assiduously were to study the fund's financial statements, and only then if she knew what she was looking for, would she realize that the fund had undertaken leverage via repurchase agreements and securities lending. Further footnotes describe the details. To be clear, I am not stating that the China Fund is doing anything wrong or that it is improperly reporting its leverage. The fact that it isn't doing anything wrong is what makes it such a good example.

Another reason standard reporting doesn't exist for non-'40 Act leverage is that the amount of such leverage can change regularly. If a fund issues $100 million in debt (regulated, '40 Act leverage), the value of the $100 million may fluctuate in the marketplace but the fund will continue to report $100 million in debt on its books until it repays the loan. However, if a fund raises $10 million through tender option bonds in its portfolio, the value of those bonds will likely change because they are typically variable-rate securities. Because of frequent fluctuations, some funds are hesitant to post the information as a stand-alone leverage amount.

Full Disclosure of Leverage Is Important
Any type of leverage carries risk and reward. If a fund's outperformance is due in part to financial leverage, investors have a right to know. If a fund's risks are accentuated by using financial leverage, investors again have a right to know. In fact, one would hope that shareholders' stewards, the board of directors, would sense an obligation to tell investors very straightforwardly that a fund uses leverage. It matters not whether the leverage was via debt, preferred shares, or a non-'40 Act vehicle. Investors should not have to dig through a fund's annual report and learn high-fallutin' financial lingo to discern whether or not their fund employs leverage.

As I mentioned above, the better fund stewards make no bones about whether or not they report non-'40 Act leverage: They report it. We believe this is a best practice. Some such fund families are actively attempting to be even more transparent, investigating whether it makes sense to report total leverage on a daily basis. Other funds don't believe it is necessary to be so transparent and are falling behind the times. Which type of fund family would you want to trust with your money?

Unfortunately, standardized reporting of leverage is a long way off. A few professional investors are attempting to create a ruckus on the issue in the hopes that regulatory bodies will take action. I believe that the industry's professional association could take a leadership role, cajoling or mandating that members standardize leverage reporting. Until one of these two events takes place, though, the issue is solely in the hands of the fund families themselves. If you are invested in a CEF and are unsure of whether or not it reports its full leverage, I'd advise calling the fund company.

In closing, let me leave you with this. PIMCO Strategic Global Government RCS, a 4-star rated fund, has a leverage ratio in excess of 50%. This makes it the most highly levered CEF out there. Try to find mention of this leverage ratio anywhere on the fund's website or in the annual report--it's not there. Investors have a right to expect more transparency from their closed-end fund companies, especially one with the stellar backing of the PIMCO brand reputation.

Click here for data and commentary on individual closed-end funds.

Mike Taggart, CFA, is the cosed-end fund strategist at Morningstar.

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