Morningstar's Parent Pillar may be underappreciated, especially for closed-end funds.
For some, investing for retirement is just another item on life's to-do list. On a scale of enjoyable activities, it may rank near filing taxes. Because life is full of busywork and because choosing specific funds can be daunting, checking in on and rebalancing retirement holdings can easily be put on the back burner and often forgotten entirely. At Morningstar, we're devoted to helping investors understand and analyze the crucial issues behind successfully picking funds. In 2011, we launched the Morningstar Analyst Ratings for Funds, a qualitative rating based on five Pillars: People, Process, Performance, Parent, and Fees. The Parent Pillar--our assessment of the firm backing a fund and its portfolio manager--may be underappreciated, especially for closed-end funds.
Across Morningstar's Fund Research team, we rate Parent firms based on five criteria that reflect how effectively those firms act in the best interests of fund shareholders: corporate culture, manager incentives, regulatory history, fees, and the funds' board of directors. As it applies to CEFs, we are particularly interested in the board of directors, manager incentives, and overall corporate culture. Of course, regulatory history and fees are important too. To check a firm's regulatory rap sheet, we look back over a decade or so for any major legal issues or SEC citations in which the fund firm has been involved. We speak with representatives from the firm to ascertain whether changes have been made (be it a beefed-up compliance department or a shift in corporate culture) that would prevent such issues from reoccurring. As for fees, while our Active Funds Research colleagues have discussed the correlation between low fees and strong performance for traditional mutual funds, for CEFs, the relationship is not as clear. In a recent study, we found that, at least for their most recent fiscal years, CEFs are more expensive on average than their open-end mutual fund peer groups. But performance is not necessarily the worse for it.
The table below lists the most recent Pillar ratings for prominent CEF fund firms, in alphabetical order. Note that not all fund firms offering CEFs have analyst coverage and therefore will not have a Parent rating. Over the next quarter, we will be adding more CEF-specific fund firms to this list. Premium members can read Parent-specific text within fund reports for both CEFs and mutual funds. Keep in mind that for firms with more than just CEF offerings, ratings are based on the entire fund firm, not just on its CEFs.
The Shareholder's Advocate
The board of directors of a CEF is often overlooked, but a fund's slate of directors does play an important role in the success or failure of a fund. Board members are not only responsible for approving changes to a fund's management team, strategy, fees, leverage, and distribution rates, but a strong and capable board will lead the charge on these changes. What's more, it's imperative that a board show a willingness to push back on fund managers and the fund sponsor when necessary. While this can be difficult to quantify, often reading a fund's proxy statements and annual reports can provide context for decisions made by the board. A strong board takes action when necessary. An example would be merging smaller funds to consolidate a firm's lineup, potentially lower fees for investors, and increase the universe of investable options (larger fixed-income funds, in particular, have the ability to purchase securities directly from firms, often at advantageous prices and yields).
For a board's interests to be properly aligned with shareholders' long-term interests, in our opinion most of its members must be "uninterested"--meaning that they are not associated with the fund, its parent company, or any affiliate of the parent firm. It's also important to understand how many funds the board is responsible for overseeing. For some of the larger fund firms, like BlackRock, Nuveen, and Eaton Vance, its members oversee nearly every fund in the firm's lineup. In the case of Eaton Vance, that's upward of 100 funds, which may be difficult for a board to keep track of. For a deeper dive into our views on the best practices for a CEF's board of directors, read this article.
Show Me the Money
Morningstar's view on manager incentives is twofold. First, we like managers to invest a substantial amount in the funds they manage. For a firm to get top marks, most of its managers must own more than $1 million in shares. Our research finds that open-end mutual funds with higher levels of manager investment tend to offer better long-term, risk-adjusted performance and lower expenses.
For CEFs, manager investment can be a difficult yardstick to use. Nearly a third of all CEFs are municipal bond funds, many which are single-state-focused, and a large percentage of funds are invested in "noncore" asset classes such as high yield. While we don't let managers off the hook completely, we generally do not require ownership in excess of $1 million funds for noncore funds. It's more than reasonable, however, to expect all named portfolio managers to own at least $100,000 in shares, and we'd like to see ownership of more than $500,000 in shares. We also consider ownership across strategies. For example, the municipal management team at Nuveen may not own a substantial amount of any single fund, but across all of the muni funds they run, ownership by top managers is substantial. This bar may seem a bit low, but many CEFs, like many mutual funds, have absolutely no manager ownership whatsoever. We shine a light on that disappointing trend by calling attention to managers with subpar ownership in our Analyst Reports, because we believe manager investment better aligns their interests with those of fund shareholders.