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From the Closed-End Fund Team Mailbag

Answering your questions about the CEF Analyst Ratings, our coverage plans, and more.

Mike Taggart, CFA, 01/13/2012

Although we try to respond to every email and post from our readers, it has been a while since we last offered a compendium of the most frequent questions we receive. We decided that it is about time that we did so, especially given the flurry of questions about our new analyst ratings and our closed-end fund, or CEF, coverage plans. So, let's delve right in.

How are the new Analyst Ratings different from the star ratings?
The Morningstar Rating for funds, widely known as the star rating, looks at a fund's historical, risk-adjusted performance. A CEF's risk-adjusted performance is then compared with its CEF category peers' risk-adjusted performance to derive the Morningstar Rating. As such, it is meant to be similar to a scorecard of how the fund has performed against its peers and to be used as one of many tools investors should consider when researching a fund. Because it is a quantitative measurement, analysts do not have input into the rating. The broad methodology can be found here.

The new Analyst Ratings are vastly different. Here, we are applying a global CEF methodology to attempt to forecast future performance from the fund. Most of this methodology is similar to the open-end mutual fund rating methodology. However, along with our CEF colleagues in London--who just launched their research reports and ratings this week--we have tweaked the CEF methodology a bit to consider leverage, sources of distributions, and a few other CEF-specific items. When assigning a rating to a closed-end fund, we are broadcasting our level of conviction as to whether we believe a CEF is likely to outperform its category peers (whether they be other CEFs, open-end mutual funds, or ETFs) over the next market cycle.

How do you determine which CEFs will have analyst ratings? How do you determine CEF research coverage?
"Coverage" is quite a misused word when it comes to research. If by coverage, one means providing simple data, then Morningstar has covered all closed-end funds for a quarter of a century. However, most people think of coverage as analyst-driven research coverage. While Cara, Steve, and I keep our eyes on all 632 closed-end funds traded in the United States, we plan to have full-blown research reports on 140 funds by the end of this year. Currently, we have 93 such reports published.

The decision of which CEFs to provide full research reports on was a difficult one. We have settled on covering the largest funds by net assets, along with their closely related sister funds. We looked at the net assets at the beginning of September 2011 and carved out a list. Because new funds get launched and net assets change, we reserve the right to make changes to the coverage list going forward. Also, in order to properly conduct our research, we need to speak to the fund managers and executives; if funds do not wish to make such people available (and two rather large fund families have so far chosen this route), we cannot cover the fund.

Every fund that we write up in a full report will also have an analyst rating. No analyst rating will be awarded without a full report being written. As such, the report and the rating go hand in hand.

If you aren't covering a fund, does that mean you don't like it?
No. We would like to cover every CEF in existence; however, that's not reasonable given our three-person team in the U.S. Instead, we focus our coverage on the largest CEFs. To round out our views on CEFs, we focus our Tuesday CEF Specialist articles on CEFs that we do not plan to fully cover via an analyst report.

There are several funds that we don't plan to cover that are very good funds. The absence of an analyst rating does not imply that we like or dislike a fund. We attempt to convey our views on individual funds when we write them up in the Tuesday articles.

How can you recommend a fund that has returned capital to investors?
As long-term readers know, we have done much to bring the issue of return of capital to light. Ongoing, consistent, heavy use of destructive return of capital is a huge red flag to us. We deplore the practice. However, there are two things to bear in mind. First, the return of capital must be destructive to be considered a red flag: That is, it must be from investors' own capital and it must eat away at a fund's net asset value and future earnings power. Constructive and pass-through return of capital is, in our minds, suitable in some cases, though we would prefer funds not use any return of capital. Second, even when a fund has used destructive return of capital, we look to see how much and how often. If a fund distributed this in one calendar year as a small portion of the overall distribution, we are likely to look the other way. It's better to not change the distribution amount and avoid the subsequent sell-off in the share price, in our opinion. We also want to see if, after returning destructive capital, the fund reduced its distribution. For ongoing destructive returns of capital, we can be quite brutal in our assessments of the fund and its executive's implied views of shareholders.

How, exactly, does a fund return capital to investors? What are the mechanics? And, are the data points at Morningstar reflecting return of capital distributions?
When you get down to brass tacks, trying to figure out how a fund can actually send investors money ascribed, for tax purposes, as return of capital is quite intriguing. If a fund receives dividends or realizes capital gains, it's easy enough to envision how it simply passes those along to its investors. But how does a fund pass along unrealized capital gains (constructive return of capital) or investors' own money (destructive return of capital)? It's important to bear two things in mind. First, the designation of "return of capital" is largely a tax issue. Money is money. Second, funds always have money either sitting in cash or easily available through a security sale, to meet distribution obligations. Portfolios are managed with an eye toward paying the distribution. So, even if a fund distributes constructive return of capital, which can be ascribed to unrealized portfolio gains, the cash is coming from somewhere else. It's easy to confuse tax accounting with real-world dynamics of managing a portfolio, when we're looking in from the outside.

All of the data points we use at Morningstar take into consideration the sources of a fund's distribution, return of capital included.

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