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Replying to Comments About the CEF Analyst Rating

Our Morningstar Analyst Ratings for CEFs have generated a lot of comments, but has anyone read the methodology behind the ratings?

Mike Taggart, CFA, 08/17/2012

Perhaps the most difficult thing to do as an analyst is to put your neck out and make a call on a security. The best analogy I have is to a referee, who calls a game-changing penalty at a crucial moment in a football game: One team's fans are going to agree with the call; the other team's fans are going to disagree; all will be vehement in their opinion. I mean this as a fact, not as a complaint. After all, making calls is a large part of the job and, ultimately, it's the only part that matters. We can pontificate on various aspects of CEF investing all day long, but if we end up with the wrong conclusions, then what's the point of pontificating? We don't operate in an ivory tower, but in the markets--which is what attracted me to the industry (and away from a graduate degree in Russian history) in the first place. I enjoy making calls.

Launching ratings on closed-end funds, or CEFs, was a big step for us, and we largely followed the lead of our open-end analyst colleagues. While in last week's article, Cara published a link to the Analyst Rating methodology document for mutual funds, we also have our own for U.S. CEF Analyst Ratings (here). We published this document not only to lay out the objective and process for the ratings, but also to serve as the basis for the inevitable scrutiny that comes about when making calls. Much of that document was written by our open-end mutual fund analyst colleagues, but in places we felt it necessary to tweak certain elements for CEFs. After all, items like leverage and destructive return of capital are not commonplace with mutual funds. In places, then, there are slight but nonetheless meaningful differences between the mutual fund ratings and the open-end ratings.

Not the Morningstar (Star) Rating
Perhaps the biggest area of user confusion so far has been between the Star Rating and the Morningstar Analyst Rating. I agree with yogibearbull's comment to Cara's article that she summed up the difference quite well: "Unlike the Star Rating, which relies solely on historical risk-adjusted performance against a peer group, the Analyst Rating is qualitative and forward-looking. Historical performance plays a minimal role in the rating, with the focus on the fund's managers, the investment process, and the parent firm."

If you're interested, the methodology for assigning the Morningstar (Star) Rating can be found here. I would like to point out two things related to the Star Rating. First, while it is a backward-looking assessment of a fund's risk-adjusted (risk equating to net asset value volatility) total returns, it's not typically a simple risk-adjusted total return assessment. For funds with more than five-year's worth of history, the three-year and five-year and (if the fund has a long history) 10-year ratings are combined into one overall rating, which means that the most recent period is more heavily weighted than older periods. This becomes important when we think about the performance pillar for the Analyst Rating because we want to look at how a fund performs on a risk-adjusted basis on a month-to-month and rolling period basis. The near-term performance weighting in the overall Morningstar Rating versus a monthly assessment is a big differentiator between the star rating and the performance pillar of the Morningstar Analyst Rating process.

Second, the Morningstar Rating compares a fund's risk-adjusted performance against that fund’s category peers. So, if the fund is a large-cap value fund, it is compared against other large-cap value peers. For U.S.-traded CEFs, there is also a very important constraint: U.S.-traded CEFs are compared only against other U.S.-traded CEFs in the same category. Our Morningstar Analyst Rating for U.S.-traded CEFs does away with this constraint. We believe investors don't care whether they invest in an asset class or sector via an open-end, closed-end, or exchange-traded fund; we believe that investors know what sector they want to invest in, and simply want to know what funds--regardless of structure--are more likely to get them to their destination. As such, when we assess past performance, we look at a CEF’s risk-adjusted net asset value total returns against the category averages for other CEFs, for open-end funds, and for ETFs.

Objective of U.S.-Traded CEF Analyst Ratings
You have to begin with the end in mind. The Morningstar Analyst Rating is the summary expression of our forward-looking analysis of a fund. The difference between ratings corresponds to differences in our level of conviction that the fund will outperform its peers over a market cycle, which we've taken to mean five years. Essentially, a Gold rating means that we have the highest conviction that the fund will, more often than not, beat its category average peer on a risk-adjusted basis over the next five years. For example, and in response to uncleDan's comment on Cara's article, in awarding Royce Value Trust RVT a Gold Rating, I am essentially making the call that I believe RVT will outperform its small-cap equity blend category average peer more often than not over the next five years. I could have made the same call with a Bronze or Silver rating, as they also denote an outperformance conviction. But, I am so convinced that RVT will post this performance, that I awarded it a Gold rating. I've stuck my neck out, though it wasn't difficult in this case.

I want to be absolutely clear on four things with regard to the objective, because I realize that questions about ratings now will eventually turn into assessments of our ability to rate funds. First, we are looking long-term, over a market cycle, which we have defined as being five years. Second, we are making a call on risk-adjusted performance. By risk-adjusted, we are using Morningstar Risk-Adjusted measures, as defined in the Morningstar Rating methodology document (here). Third, we are looking at net asset value total returns--not share price total returns; the upshot being that a fund could have great NAV performance and still underperform on a share price basis. Fourth, we are looking at performance in relation to the CEF's Morningstar category average peer, regardless of whether that peer is a CEF, a mutual fund, or an ETF; we aren't going to benchmark performance against some customized list of funds or funds that look like they should be peers; we aren't going to consider performance against the top decile performance.

The comment by uncleDan points out the need to be very clear on this, in my opinion. He wrote, "When I compare RVT to an equivalent ETF, Vanguard's VB, I find that VB since inception has clobbered RVT. VB would be 70% higher than RVT. How is RVT deserving of a gold medal?" This is a good question and uncleDan is on track by comparing two small-blend category portfolios. Vanguard's VB refers to
Vanguard Small Cap ETF VB. And he isn't wrong in his assessment of past performance, but I have three comments. First, the performance pillar of our Analyst Rating methodology is one of five items we're assessing. This is largely because of the trickiness of analyzing past performance. Yes, on an absolute basis, VB very well may have clobbered RVT since inception. Certainly it has over the past five years. Switching around time periods often leads to differing opinions, though in this case it doesn't.

Second, we are looking at risk-adjusted performance with our methodology. Interestingly, in the 102 months through July 31, 2012, that these funds have coexisted, RVT outperformed VB on our risk-adjusted basis 51 times or 50% of the time. This isn't surprising, given VB's portfolio, but it is interesting that it's right at 50%. When we aggregate those months into rolling five-year periods, of which there are 43, RVT is batting 0.000. VB won every time over five-year periods. RVT's months of excess returns were more than diminished by periods of underperformance.

Which brings me to the third point: Our ratings are against averages. Clearly, based on this assessment, VB is the superior fund, but we are looking at two funds that have been superior to their average peer in the past. It's like we're comparing Kobe Bryant and LeBron James, arguing that one of them is horrid, when in reality any owner would be happy to have either one on the team. My Gold rating reflects my high conviction, based on our methodology's five pillars of assessment, that RVT's past performance will be replicable into the future.

One Last Thing
Another comment posted to Cara's article, this one by openmind, brings up the subject of premium and discounts. This is very pertinent, and a great question for someone who describes himself or herself as new to CEFs. Our ratings are concerned with the CEF and its NAV total returns. We are essentially making a call on whether a fund is a good investment vehicle to help you reach your investment goals. We are not making a market call, though. Premiums still need to be considered.
Western Asset High Income II HIX is a Bronze-rated CEF trading at a nearly 17% premium; to us, investors should avoid that high premium, regardless of our level of conviction on the fund's underlying future performance.

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

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