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Three Closed-End Funds That Are Delicious--With or Without Gravy

We serve up the three CEFs on our coverage list with the highest Morningstar Analyst Rating.

Mike Taggart, CFA, 11/24/2011

Thanksgiving dinner. For most Americans, the very thought conjures memories of family, friends, and traditions stretching back to childhood. Regardless of where we are in the economic cycle, through good times and bad, Thanksgiving ushers in a period of racing to and from stores, holiday parties, and the like. The madness can be overwhelming and leave little time for reflection. But before all of that mayhem ensues, the Thanksgiving dinner itself reminds us of life's simpler pleasures.

It's also a good time to take stock of what has transpired during the year. Back in January, we began publishing reports on closed-end funds, or CEFs, based on Morningstar's Global Analyst Rating methodology. Since then, we have launched coverage on nearly 90 CEFs. These reports, available to Premium Members of Morningstar.com, run to four printed pages (five if they are in a PDF format). In 12 different sections, we consider topics such as leverage, fees, the investment process, the portfolio, past performance, and management.

In the end, our assessment of the CEF is summarized by our qualitative, forward-looking rating. This rating is meant to serve as a guidepost, alerting investors as to which CEFs we believe are best positioned to outperform their peer group over a market cycle, on a net asset value basis. This rating, like the star rating, is not meant to be an explicit buy rating, as we believe investors themselves are best suited to make that decision, based on their investment objectives and asset-allocation needs. This rating, then, is meant to serve as another tool to help you decide which investment vehicle can best help you reach your goals.

For this holiday, we have decided to share with all of our readers the Morningstar Opinion section from the reports on the three highest-rated CEFs under full analyst coverage.

Have a Happy Thanksgiving!

Aberdeen Asia-Pacific Income FAX
(The opinion was written on Oct. 24.) Aberdeen Asia-Pacific Income FAX is the only CEF that provides investors with an avenue to the difficult-to-reach debt markets of developing Asian nations as well as Australia. Moreover, managers undertake an extremely comprehensive investment process in an attempt to locate undervalued securities in these markets. As these regions capture larger and larger portions of the global economy and as the debt-addled developed economies continue to falter, investors looking for diversified income will be hard-pressed to find a better option. For these reasons, we give this fund our top rating.

The fund was launched by the Australian EquitiLink Group in 1986 as the First Trust Prime Australian Income Fund and was one of the few funds available for investors to gain access to the Australian sovereign debt market. Aberdeen acquired EquitiLink, and hence this fund, in 2000. Keeping with the tradition of providing investors with access to new markets, Aberdeen expanded the fund's investment policy, allowing it to invest in Asian debt as well. These markets are highly illiquid, and the fund's size allows it to take advantage of lower transaction costs. China and India, for example, require foreign investors to buy a license in order to invest in non-U.S. dollar-denominated bonds issued within their borders. However, a fund of this size (with close to $2 billion in total assets) still has to be mindful of the liquidity problems associated with investing in the region.

Portfolio managers don't just conduct regional and sector research by sitting at a computer but actually travel to the regions they plan to invest in and observe their economies firsthand. The team has offices in Singapore, Bangkok, and Sydney and also makes use of other Aberdeen offices around the world to formulate a global macroeconomic outlook. This allows managers to acquire the necessary information to invest in these regions that the individual U.S investor may not have access to. The fund's in-depth process has rewarded investors with an annualized total return of 12.7% over the past 10 years.

This fund has exposure to sovereign and corporate debt in 20 different countries, while holding 12 different currencies (though most of the currency exposure is concentrated in Australian and U.S. dollars). Although the fund has average expenses and managers do not own shares, these negatives are more than offset by the fund's unique process and portfolio positioning, in our opinion.

AllianceBernstein Income Fund ACG
(The opinion was written on Oct. 26.) This top-rated fund launched in 1987 and is the longest-standing fund in the U.S.-government closed-end fund peer group. It has produced impressive results, beating peers and its benchmark over the long term. Its distribution policy is strong and stable and its fees are the lowest in the peer group. What's more, two managers have a substantial ownership in the fund and many board members also own shares.

The fund's strategy is focused on income generation through investments in mainly government-issued and government-backed securities. This could lead to a portfolio heavy in U.S.-government bonds. To diversify, the fund can also hold 35% of its assets in below-investment-grade bonds, non-government-issued securities (in particular corporate bonds and mortgage-backed securities), and foreign-government bonds. In practice, the fund does extend its holdings to emerging markets and to mortgage-related bonds. This is unique among peers and such securities have provided a boost to performance and to the distribution.

Overall, this fund's performance has been very strong on absolute and relative bases: It's up nearly 15% over the latest three-year annualized period. On a relative basis, the fund has outperformed the government-leveraged CEF peer group's average performance in each of the past six calendar years. (We chose 2005 as a starting point because three of the four funds in the group were launched between 2003 and 2004. This was the first full calendar year of existence for all funds in the group.) Performance against the benchmark, the Barclay's Capital U.S. Aggregate Bond Index, is also strong. The fund has outperformed in eight of the past nine calendar years and is matching performance in the year to date.

We also like the fund's distribution policy which is strong, steady, and stable. The typically income-only distribution was lowered by 20% during 2010 as interest rates fell globally. Investors should appreciate that the fund lowered the distribution to reflect its future income-generation potential as opposed to returning capital to investors. Its 5.4% distribution rate (at NAV) is greater than the peer average of 4.8%, and its income-only distribution rate is the highest in the group.

Investors should be particularly pleased with the fund's low fees. Its fiscal 2010 expense ratio was the lowest in the peer group and the fund has capped annual management fees at 0.95% of net assets (assessed on a monthly basis).

Finally, we are happy to see strong management and director ownership of shares. Two managers own more than $100,000 in shares and most directors own shares.

Royce Value Trust RVT
(The opinion was written on Sept. 27.) Royce Value Trust is an elite-rated closed-end fund that invests primarily in small-cap U.S. equities. It has a well-regarded portfolio manager, sponsor firm, and investment approach. We also find it to be highly shareholder-friendly, as best exemplified by its management-fee structure. Investors should be aware of a potential upcoming distribution related to a proposed new fund, Royce Global Value Trust.

Portfolio manager Chuck Royce brings nearly 50 years of investment experience to bear on this fund. He also owns more than $4 million worth of shares, and we believe his interests are aligned with shareholders'. Fund sponsor Royce Associates is highly regarded in the investment industry for its expertise in managing portfolios of small-cap firms. With $40 billion in assets under management and as a wholly owned subsidiary of Legg Mason, this is not a firm that is in danger of dissolution when Chuck Royce decides to retire. Finally, the investment approach of Royce Associates' analysts and portfolio managers is rooted in the fundamental valuation process laid out by Benjamin Graham. Analysts use discounted cash flow models and "enterprise conviction" to determine whether a security is trading at truly cheap valuation levels.

The fund is shareholder-friendly, in our opinion. The fund's website and annual report offer significant and detailed information to investors. The annual report itself lays out the benefits of closed-end fund investing, a rarity for firms that also offer open-end mutual funds.

Perhaps the shareholder-friendliness is best reflected in the fund's management investment-fee structure. Each month, the fund pays an investment advisory fee of one twelfth of 1% of the average month-end total assets (net assets plus preferred capital) over a rolling 60-month period. This is adjusted up (or down) for performance exceeding (or underperforming) the S&P 600 Index over the same period. However, if the fund's 36-month trailing NAV total return is negative, no investment advisory fees are charged for that month. Further, if the fund's average annual total NAV return since issuance of the preferred shares is less than the preferred shares' dividend rate (5.90%), fees are not assessed against preferred capital for that month.

Investors should also be aware that shareholders will vote whether to authorize a $100 million spin-off of this fund, which would provide seed capital for a new fund, Royce Global Value Trust. This would be effected through a distribution of shares in the new fund. We believe this is a unique method of starting a new closed-end fund, bereft of the premium issue that dogs most IPOs. Royce Value Trust already invests more than 20% of its assets in non-U.S. companies, and Royce Associates has been investing abroad for about six years successfully.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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