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Measuring Stewardship in Closed-End Funds

Morningstar's Parent Pillar may be underappreciated, especially for closed-end funds. 

Cara Esser, 02/22/2013

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.

Parenting Skills
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.

In our analysis of incentives, we also consider the composition of management's compensation. Ideally, managers should be rewarded for long-term performance relative to a clearly defined (and unchanging) benchmark or peer group. Most CEF managers receive a base salary with a bonus based on performance of the individual funds or overall firm performance. The time period over which bonus performance is measured varies, but we prefer that bonus compensation be based on longer-term performance of at least three to five years. We believe it is a best practice for firms to use fund shares (shares of the fund or funds a portfolio manager oversees) as a component of bonus compensation.

In general, we don't believe it is a best practice to reward managers for firm performance over fund performance. While firm performance is influenced by fund performance, this type of compensation scheme may provide incentives for behavior that is good for overall firm growth but may hurt a specific fund's results. For example, a manager may want to pursue a new fund or strategy, which would increase the firm size and his own assets under management. But, depending on the circumstances around a new fund launch, it may spread resources thin as managers and analysts must devote time and energy to managing another fund.

Finally, we consider how advisor fees are calculated. Firms that levy advisor fees on gross assets as opposed to net assets may be giving managers incentive to take on more leverage than is prudent in an effort to increase management fees.

Culture Club
Of the criteria we assess to assign a Parent Pillar score, a firm's corporate culture is perhaps the most difficult to measure. For each fund we rate, analysts regularly speak to portfolio managers and analysts about portfolio strategy, composition, and performance. Analysts are also assigned to each Parent firm we rate, and they speak with professionals throughout the firm--including board members, compliance officers, CEOs, other top executives, portfolio managers, analysts, risk managers, traders, and so on--to gauge corporate culture. On an ongoing basis, our analysts conduct due diligence visits with firms to learn more about their culture firsthand.

We believe a positive corporate culture is reflected by low employee turnover, long manager tenure, an environment where dissenting team members are not afraid to speak their minds, and a history of transparency with investors--that last element is especially important for CEF investors who are often left in the dark by firms disclosing the bare minimum. Individual investors can get a glimpse of corporate culture by reading manager discussions within annual reports and reading quarterly or monthly updates from managers usually found on firm websites. Not all CEF fund families offer such regular access to investment updates or big picture ideas from the firm, but a lack of shareholder communication and transparency speaks volumes as well.

Stewardship is a key building block in assessing which funds you should consider for your portfolio, and it should be taken as seriously as past performance and fees. For many investors, past performance and fees steal the show, and the Parent Pillar can serve as a "gut check" for determining which firms they invest with. Others may use the Parent Pillar as the first screen and weed out firms that garner Negative (or Neutral) Parent scores, preferring to invest with firms that have proven an ability and desire to do right by investors. At Morningstar, we pride ourselves on putting investors first. Our Parent evaluations are a way for us to pinpoint firms that do the same.

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

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