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2 Places to Find Leverage Amounts for Any Fund

Many readers want to know how much effective leverage is in their closed-end fund. Although such information is on our site, these do-it-yourselfers want to go to the source. We show them how.

Mike Taggart, CFA, 03/23/2012

A recent article I wrote about PIMCO Strategic Global Government RCS engendered quite a discussion about leverage transparency among readers. Many readers agreed with me that the fund should be more transparent about its use of non-1940 Act leverage. This is the type of leverage that arises from modern-day financial flexibility within the portfolio, as compared to when a fund issues debt, draws on a line of credit, or has outstanding preferred shares. My point was not that the fund was overleveraged (that's a matter for individual investors to decide, in my opinion) or that anything untoward was going on, but rather that PIMCO should be more transparent about the fund's use of non-1940 Act leverage.

Other readers, longtime discussion-board contributor capecod in particular, disagreed. In their view, the leverage is disclosed in the annual and semiannual reports and, to paraphrase, investors who don't understand where to find that information should probably not invest in the fund in the first place.

I do believe that we all should understand what we invest our money in. It’s the 10-minute rule: If you can't figure out how any fund is operating and generating total returns and distributions within 10 minutes, move on to another fund. If too many red flags pop up or you feel like your digging is leading to more questions than answers, likewise, move on to another fund.

However, this process can be tricky. After all, more often than not, we don't know what we don't know. And developing an investment paradigm for closed-end funds, or CEFs, takes time and effort. I don't believe that investing should require a background in advanced finance or accounting--though I have both. Our job as analysts at Morningstar is to dig through the information and present it to you in a distilled form. For example, on Morningstar.com, you can find the total leverage ratio, the 1940 Act leverage ratio, and the non-1940 Act leverage ratio for every CEF traded in the United States. We believe that this information, along with other data points offered free-of-charge on our website, gives you the information you need to make informed investment decisions.

Still, given the heated discussion that cropped up after my article on RCS, I think a deeper delve is in order. Some readers wanted to know how to find this information in the annual report and, in our recent CEF Survey, many participants also asked for more hands-on type instruction. For this exercise, we'll stick with RCS, which as I noted has had terrific risk-adjusted performance, and we'll look at how to find the fund's leverage in its most recently published annual report, dated Jan. 31, 2011 and available on the fund family's website.

Leverage is disclosed in two places in an annual report. It's in both the schedule of investments and in the balance sheet. If you click on the link above, then go to the "Documents" tab, and then click on the Annual Report, you can see this for yourself. Though the data are over a year old, they still suit our purpose.

On Page 9 of the annual report, the schedule of investments begins. This schedule is a list of all of the fund's holdings as of Jan. 31, 2011. It's a snapshot in time, just as the balance sheet will be. Scrolling through the list, you see what the portfolio was invested in on that date. That's interesting in and of itself. But to find the leverage, you need to go to the end of the schedule on Page 26. There you will see that the value of the portfolio's total investments was $1,188,636,118. Liabilities (here a synonym for leverage) were $793,941,305, leaving net assets of $394,694,813. In other words, on Jan. 31, 2011, the fund had roughly $2.01 in liabilities for every $1.00 in net assets in the portfolio. That doesn't include the effective leverage from the options or convertible securities positions.

The balance sheet will tell a similar, though slightly different story. That's because the schedule of investments total of $1,188,636,118 is simply one of the assets listed on the balance sheet. This is true of every fund, as CEFs typically have assets outside of the portfolio. However, the portfolio value is always the largest asset on the balance sheet. Page 28 of the annual report shows the fund's balance sheet. Total assets were $1,405,610,128. You can see that, in addition to the portfolio value, the fund had cash on hand, a few receivables, and other assets.

Looking at the liabilities, one thing jumps out to those of us familiar with balance sheets: There is no debt outstanding. Looking further down at net assets, commonly known as equity, there is also no sign of preferred shares outstanding. So, as I and several other readers pointed out in my initial article, it is perfectly legitimate for this fund to state that it has no preferred share leverage. In fact, to state otherwise would be incorrect.

Balance sheets have to balance, for those of you who aren’t familiar with looking at them. The equation is: assets = liabilities + equity (or, here, net assets). Another way of viewing this is: net assets = assets – liabilities. So, the question arises, if the fund has no debt or preferred shares outstanding on the balance sheet, where does the leverage show up? It shows up in the liabilities section as various "payable" items.

Note that, although the total assets on the balance sheet do not equal the total investments on the schedule of investments, the net assets from the balance sheet and from the schedule of investments are the same: $394,694,813. From a balance sheet perspective, this fund was leveraged by $1,010,915,315--or even more than the schedule of investments suggested--on Jan. 31, 2011. In other words, the fund had borrowed about $2.56 for every $1.00 it had in net assets.

This is how leverage is disclosed in financial statements for CEFs. It works for every CEF out there that has a published annual or semiannual report. The same approach can be used for open-end mutual funds.

To put RCS' leverage into context, it may help to look at a couple of other securities. First, sticking with PIMCO, let’s take a look at PIMCO Total Return PTTAX because, yes, open-end funds can use non-1940 Act leverage in their portfolios. According to the fund's semiannual report, dated Sept. 30, 2011, the fund had $340.4 billion in assets and $242.1 billion in net assets; in other words, it was borrowing about $0.41 for every $1.00 in net assets. Second, let's look at a blue-chip company--one that capecod mentioned in one of his comments-- General Electric GE. In the most recent annual report, for the year ended Dec. 31, 2011, the company listed $717.4 billion in assets against $118.1 billion in equity. This blue-chip bellwether, then, is leveraged $5.07 for every $1.00 of equity. Compared with General Electric, RCS' leverage total (at the most $2.56 for every $1.00 in net assets) looks like kids' play. Again, I want to be crystal clear that I have no problem with CEFs using leverage, even to the extent used in RCS. Leverage magnifies returns to both the upside and downside. This fund carries a 5-star Morningstar Rating for funds. The star rating looks at historical total net asset value returns that are adjusted for volatility. Leverage magnifies volatility. This quantitative rating, which neither I, Cara Esser, Steve Pikelny, nor any analyst has input, tells you that the fund's returns have been strong enough to compensate investors for the extra volatility and that its risk-adjusted returns have been at the top of its CEF category. As I stated in my initial article, such performance suggests that portfolio manager Dan Ivascyn has done a stellar job in managing the leveraged portfolio. For instance, in the downturn of 2008, the fund posted a net asset value loss of 13.68% while its intermediate-bond CEF average peer dropped 14.70%. In 2009 the fund outperformed its peer group, and in 2010 the fund's total return performance was nearly twice that of its average peer.

Whether you choose to invest in a leveraged CEF or not is, in my opinion, an individual choice. Some investors eschew leveraged funds altogether. Others don't mind the additional volatility. My view, though, is that fund companies, too, make a choice as to how transparent they are about their use of leverage. Yes, Morningstar.com and a couple of other websites can tell you how leveraged a CEF is. And hopefully, after reading this article, you can now determine a fund's leverage for yourself.

In any event, I'm a big believer in knowing what you're invested in. Too many times I have had former CEF investors tell me that they will never again invest in a CEF because the funds are too opaque. For most CEFs, I don't think this is the case, but one bad apple can spoil the lot for some investors. With any investment, the best piece of advice is "buyer beware." Before investing, look at all of the resources and, with this article in hand, check out the fund's schedule of investments and its balance sheet. Once you've looked at a few of them, you'll likely be surprised about how much jumps out at you.

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