Three industry veterans give a behind-the-scenes look at how an investment idea reaches the market.
This article first appeared in the June/July 2011 issue of Morningstar Advisor magazine. Get your free subscription here.
The closed-end-fund business is on a roll. In 2010, there were $8.4 billion in net proceeds raised across 20 issuances--for an average of about $420 million per IPO. So far this year, seven closed-end funds have launched, attracting $2.3 billion, and the industry is on track to have an even bigger year in terms of the net proceeds.
With this flurry of recent issuances, I thought it would be interesting to dig into the process of how a closed-end fund is born. The IPO--perhaps the most controversial aspect of closed-end-fund launches--is just one component of a larger process of bringing a new product to market. To help explore this topic, I assembled a panel of experienced fund executives at the Capital Link Conference, which held its 10th annual meeting on April 27 in New York. Capital Link is the largest closed-end fund conference. Contributing to my panel were Bill Meyers, senior vice president of product development for Nuveen; Bill Golden, managing director of closed-end funds for Legg Mason; and Stephen Dougherty, CFA, head of structured assets and alternatives for ING Investment Management. Here is a transcript of our discussion. It has been edited for clarity and length.
Mike Taggart: Let's look behind the scenes a little bit of how a closed-end fund reaches the market. Most of us are aware of IPOs, but Bill Golden, can you walk us through the process of creating a new closed-end fund?
Bill Golden: The first thing you need to focus on before you bring out a new product is your secondary market support. Unless you are committed to supporting your fund after it's sold, you are not going to get a commitment from others to distribute the fund. Financial advisors aren't going to want to invest with you if they don't have confidence in your commitment to secondary market support. The underwriters aren't going to want to give you a calendar spot to bring a fund to market. And your sales folks aren't going to want to sell a product if you don't have an infrastructure to support it.
So, I don't think it's a surprise that my two colleagues here on this panel both received shareholder support awards and that they're active in the IPO market. The secondary market is an important element. It's important for us, and I think the fact that many of you are here shows that it's important to you, as well. So, I would start with good secondary-market support.
I think the magic, or really the challenge, of creating a closed-end fund is coming up with an investment strategy. You want a strategy that meets clients' needs, that is timely, and is different. We've launched a fair number of funds recently, and every one had a unique genesis. We had ideas that came to us. Portfolio managers called up and said, "Munis are screaming cheap. We should do a fund." And we start working on it.
We also look at what's happening in mutual fund flows for ideas. We look at how closed-end funds are trading as a sign of demand. We try to marry those up with our capabilities. That's where the ball gets rolling, and we have a beginning of an investment thesis.
When we start to get those ideas together, we put them through a filter, if you will, and we ask a lot of the same questions that we know the underwriters are going to ask. We want to know first of all whether we have the investment capability. We want to know how similar funds are trading. We want to be comfortable that there's a good reason that the strategy is in the closed-end-fund structure and not another structure.
And there's one other important part--oh, yes, [distribution rate]. ... What is the distribution rate? Based on that, what are the sources of risk that you take on? Because there is risk in any portfolio, so you want to understand that and you want to understand how it's going to be competitive.
At the end of the day, you're looking for the type of investment strategy where you can have a differentiated product with [a distribution] that's competitive with its peers in a category in which there are signs of demand. When we get that, then it's pretty simple. You work out the parameters, put together a model portfolio, and start working with syndicate folks to try to convince them of the investment thesis that you believe in. From that process, obviously, you start creating marketing materials. There's road-show planning and--really importantly for us and I'm sure for others--the sales training. You have to make sure folks are educated when you hit the market.
Stephen Dougherty: I just want to add something to what Bill said. We find that the product-development process itself is very collaborative with our underwriters. So, in looking at our expertise and the types of portfolios we can create and the ideas that we can bring to market, we have to make sure that it's something that aligns with the strategies of the lead firms that are going to represent our deals and sell them. It has to be sellable, too. These are all among the many steps that go into creating a strong closed-end-fund offering.
Bill Meyers: I'd also echo a lot of the comments that Steve and Bill made about the new-issue market. The ability to come to market is oftentimes predicated upon how well you support the funds that have issued before it, because you want to generate the trust with the advisors and the investment bankers that help bring the product to market.
So, through this collaborative process, which again, always includes the advisor, we need to tailor a product that can work over a long period of time in a lot of different interest-rate cycles and investment markets.
Durable Investment Themes
Taggart: What investors want in a closed-end fund obviously varies based on market environments. Steve, in today's marketplace, what are investors looking for?
Dougherty: Today, it's durable investment themes. These are closed-end funds that are total-return focused and for longer-term investors. Last year, we launched ING Infrastructure Industrial IDE, which was an infrastructure fund that really caught a period of optimism in the retail market for an equity offering. It was one of the few equity offerings that was done outside of MLPs in 2010, and investors were well rewarded for that with a high total return on both a price and NAV basis.
We also want to be thoughtful of the many different levers that you can use in a closed-end fund--leverage, call overwrites, puts, currency hedging. I think these are all different things that can really help shape the risk/return profile of a closed-end fund. So, it's not only about responding to different markets, but also it's about responding to different investor needs within those markets.
At ING, what we find most important is that our funds do what they say on the label. We really focus on making sure that investors and analysts are very much aware of what we're doing to generate returns and reduce risk--or in instances of leverage, increase risk--in our funds. As such, we have our websites, we have our fact sheets, and we have an analyst day--where we work to communicate exactly what our funds do.
Taggert: A lot of times, obviously, closed-end funds are built around income solutions for investors. But then there are times when we are in a market cycle or maybe a regulatory change comes about that enable us to launch a strategy that is most suitable to be in a closed-end structure.
Bill Meyers, I was hoping we could talk, because a good example of how closed-end funds can come to the marketplace to provide a unique solution for investors is the Public-Private Investment Program, or P-PIPs, that were launched last year. You guys have two of them.
Meyers: Those are Nuveen Mortgage Opportunity Term JLS and Nuveen Mortgage Opportunity Term 2 JMT. Thinking about the backdrop of the markets, the government created the Public-Private Investment Partnership program in 2008, in which they endeavored to help banks get certain assets that were illiquid and toxic off their balance sheets, free up capital for the banks, and help the economy through increased lending from the banks once those assets came off the books. So, with the Federal Reserve, the FDIC, and the Treasury, they created the P-PIP program.
Bill mentioned investment capability. Nuveen was not one of the members of the chosen firms that were selected by the government to run P-PIP portfolios, but we do have a very good relationship with a firm, Wellington, that was offered participation. So, we looked at the partnership we had with Wellington and P-PIP as a product in a fund that addressed a lot of the needs we're talking about in the market. It was a compelling opportunity we saw. It was a competitive and a unique product, and it was also very timely because there was a window within which the P-PIP program and the ability to buy some of these assets would close.
So, we structured a product with Wellington that provided investors access to something they would not have been able to get on their own. We were able to provide investors access to an institutional strategy through the mortgage-backed securities that Wellington bought for the funds.
Since they've been issued, the funds have done reasonably well. They've held up in terms of share prices; total returns are approaching 8%. These are 10-year funds, so they'll sunset around the time that a lot of the securities within the fund will sunset.
So, again, the funds were something that was very timely and allowed investors to take advantage of what we felt was a compelling, long-term, total-return opportunity.
Golden: Our fixed-income affiliate, Western Asset, was a member of the P-PIP. Nuveen, frankly, had cracked the code in structure, and the investment opportunity was--and still is, in our view--tremendous to be able to invest in those. So, kudos to you guys for figuring that out, and it's been a great investment.
For us, we've seen a lot of institutional investment in the fund because it is the best way for some of those investment firms to buy it. They like the structure as well. The more we can get institutional folks looking at closed-ends and having a good experience, the better off we'll all be.
Taggart: Steve, ING launched the Emerging Markets High Dividend Equity Fund IHD this morning. It's a timely offering, but it's also rather unique. Please tell us about the fund and why it was this market environment that made you guys bring it to the public.
Dougherty: We thought there was a tremendous opportunity for a variety of different reasons. The emerging economies have a much lower debt/GDP level than do most developed nations. They're running about 30%. Developed nations are closer to 100%. In the BRIC countries, the majority of the population is moving into the workforce. In developed nations, most people are moving into retirement age. So, we felt very strongly about the growth story in emerging markets. Emerging markets outperformed U.S. markets by more than 8% annually over the last decade.
We also noticed a better alignment between shareholder interest and management, whereby dividend growth rates were actually higher in emerging markets than they are in most developed markets--not only higher in the large caps, but there were dividend-paying companies in small caps and mid-caps.
We realized that there was no other actively managed emerging-markets high-dividend fund, open or closed, available to U.S. investors. We really saw this as an opportunity. Also, in speaking to the strategists on the Street, one of the major overweight calls was emerging-markets equities. So it was a very nice alignment of our view and the Street's view.
In addition, this was a great opportunity to bring together a number of things in a closed-end fund that ING excels in. One is high-dividend investing. We have a global platform that manages approximately $12.5 billion in high-dividend equity strategies across many different portfolios and funds. We have a derivatives team that manages approximately $15 billion in derivative strategies, so this fund had a modest call overwrite strategy of 20% to 30% at inception. We also have a fairly large global footprint. We have offices in 34 countries, 18 of which are in emerging markets.
So, in terms of thinking about the closed-end-fund market and an alignment of where we saw an opportunity and where the Street did, we saw IHD as a great opportunity to bring a timely and durable investment to retail investors.
I would also add that in terms of open-end versus closed-end funds, oftentimes it's much easier for us to bring ideas more quickly in the closed-end-fund market. In the open-end fund market, it can take us a year or more to get something to retail investors. The closed-end funds enable us to adjust a risk/return profile of certain market returns and, at the same time, bring not only durable market ideas to investors but do so in order to capture tactical opportunities.
Mike Taggart, CFA, is Morningstar's director of U.S. closed-end fund research.