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The Results Are In: What Makes CEF Investors Tick?

The results from our first CEF reader survey show a strong desire for increased CEF education. 

Cara Esser, 03/30/2012

In late January, we put together a survey to better understand you, our closed-end fund, or CEF, readership base. We wanted to get your opinions about CEFs in general, find out why you do or do not invest, and ask your opinion of Morningstar's CEF coverage. We appreciate the time that all participants took to respond to the survey. We read every comment, analyzed the results, and, in some cases, acted on suggestions. In this week's article, we highlight some of the findings.

A big takeaway from the survey is that many respondents want more CEF education. Both individual and professional investors alike noted a general lack of understanding and information as roadblocks to CEF investing. However, there was also a general unawareness about our purely educational CEF Solutions Center, which we believe provides a great resource for beginning, intermediate, and more advanced CEF investors. In addition, Mike Taggart and I spent the first year of CEF coverage speaking to the basics of CEFs and how to analyze and invest in them. Newer readers may benefit from taking a look at our article archives (here and here).

Another big takeaway was the desire for income. In our opinion, the current investing environment is great for CEFs. The baby boom generation is hungry for income to meet their financial needs in retirement. But, interest rates are low and inflation is leaving many traditional fixed-income investments with near zero, or worse, negative, yields. CEFs are more attractive and viable options than ever before.

Individual Investors
The survey was taken by both avid CEF investors and those who had minimal or no experience investing in CEFs. Most survey respondents identified themselves as individual investors and the remainder investment professionals.

An overwhelming number of individual investor respondents described themselves as self-directed investors whose main investment goal was to meet retirement needs. Income generation was a close second, not surprising as this is closely tied to meeting retirement goals. The most popular investment vehicles investors currently use to meet investment goals are individual stocks and mutual funds, followed by exchange-traded funds, and then closed-end funds. Most individuals identified themselves as buy-and-hold investors (holding longer than five years), but many said they hold securities until their investment goals are met, which could be both very short- and longer-term horizons.

Most respondents (65%) said they owned CEFs. (The survey was taken by people generally interested in CEFs, creating a bias towards this answer.) Of those owning CEFs, 35% responded that the funds make up to 5% or less of their total portfolio while 34% said CEFs make up between 5% and 19% of their entire portfolios. More than half of CEF investors generally own between two and five CEFs at any given point in time. Some avid CEF investors (6%) said they may own more than 20 CEFs at any one point in time.

To better understand the appeal of CEFs, we asked, "What attracted you most to investing in CEFs?" Given that most respondents are investing for retirement, it's not surprising that nearly 60% said that income-generation potential "mattered most." This was closely followed by the ability to purchase shares at a discount to net asset value. What mattered least? The ability to trade funds intraday. On the subject of trading funds, most individual investor respondents are not trading CEFs regularly: 37% said they traded about one holding every few months to one year for rebalancing purposes, and 27% said they buy once and hold for years.

When investing in CEFs, more than half of respondents prefer sector-specific fixed-income and domestic-equity funds. The least popular category among investors was alternatives (long/short funds, option overlays, currencies, and commodities), but it still accounted for 20% of responses. (For this question, investors were asked to choose each allocation type that they used.)

When asked to rank CEF attributes in order of importance when making an investment decision, investment strategy and distribution income were a near tie for the "most important" attribute. For all the hype and concern over leverage, nearly 40% of respondents said that leverage was the "least important" attribute when making an investment decision.

About 35% of individual respondents said they have never invested in CEFs, the desire to learn more about CEFs being cited as the main reason for not using them. Many also said they prefer ETFs and mutual funds to further their investment goals. Unsurprisingly, a CEF's income-generation potential would be the most enticing characteristic to entice these non-CEF investors to consider adding CEFs to their portfolio. ‚Äč

Financial Advisors and Professional Investors
Aside from individual investors, the other track of survey participants identified themselves as financial professionals. Most said they were financial advisors (73%) and 50% have between $10 million and $100 million in assets under management. When making investment decisions for clients, total return potential was far and away the most important attribute of a security (73%).

Similar to the breakdown of individual investors, about 65% of advisors currently invest or have invested their client's money in CEFs. Of these respondents, more than half said CEFs account for less than 20% of their assets under management, but 4% said CEFs account for more than 50% of assets under management. Seventy-five percent hold between one and five CEFs in a typical client's portfolio and various fixed-income CEFs are the most popular type of fund held. Trading habits are similar to individuals', with trades generally executed infrequently, for rebalancing purposes.

More than 95% of professional investors using CEFs do not invest in CEF IPOs and when asked to choose the top two reasons why they do not, most cited "as a general rule, I do not invest in CEF IPOs" and the desire to wait until a fund's premium dissipates. Obviously, CEFs wouldn't exist without broker participation in the IPOs, so again the survey shows its participation bias. While we believe that a general "I do not invest in CEF IPOs ever" rule does a disservice to investors and to CEFs as a whole, given Mike's two-part article showing the since-inception total returns of CEF IPOs, it's clear our view is not popular with our audience.

Of the 35% of professionals that do not invest client money in CEFs, the most stated reason was a lack of interest in trading funds intraday, closely followed by a desire to learn more about CEFs. Mirroring individuals, these non-CEF professional investors would be enticed to purchase CEFs for clients based on their income-generation potential and the ability to purchase shares at a discount to NAV.

Morningstar's CEF Coverage
More than 90% of all respondents (both individuals and professionals) picked Morningstar as their primary source of CEF information, which again isn't surprising given the selection bias of our survey. Respondents were asked to choose two sources, and 45% chose CEF Connect while 30% chose fund company websites, press releases, and filings as primary sources of CEF information. Forty-five percent said they visit Morningstar's CEF Center either daily or a few times per week. Forty-two percent of respondents found our individual CEF analyst reports to be the most valuable tool in our arsenal, and, as I mentioned previously, 30% found our Solutions Center to be the least valuable tool. Nearly 80% of all respondents said that our Analyst Ratings were either "very important" or "somewhat important" when making investment decisions. Overall, 70% said they were either "very satisfied" or "satisfied" with Morningstar's CEF coverage, education, and data.

When asked which CEF topics are of the most interest, more than half of respondents chose "basic information about CEFs" and a CEF screening tool. Many were also interested in investible ideas and a CEF model portfolio. As for investable ideas, we strive to include these into Weekly Articles and highlight individual CEFs every Tuesday in our CEF Spotlight series. And, we are working to launch a CEF model income portfolio. Stay tuned! The CEF screener, unfortunately, may take a bit longer than we'd like, but a version of the screener now used in our institutional products will be reprogrammed for use on our website. We will not stop asking for resources to create a world-class CEF screener and other great tools for our readers.

In the comments section, numerous people asked for undistributed net investment income (UNII) balances and the percentage of a fund's holdings in bonds subject to the alternative minimum tax to be displayed on Morningstar.com. I am happy to report that Steve Pikelny has been working with our data team to add both of these data points to individual CEF quote pages.

A huge thank you to everyone who participated in the survey. The responses are invaluable to us in helping to improve Morningstar's CEF coverage. If you didn't have a chance to take the survey and want to provide feedback, you can leave your comments at the end of this article.

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

Cara Esser is a closed-end fund analyst at Morningstar.
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