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Thoughts on Income From the Capital Link Forum

Morningstar's Mike Taggart weighs in on the annual conference's general theme and how it relates to the CEF industry.

Mike Taggart, CFA, 04/26/2013

This week, we attended the annual Capital Link Forum in New York. For the third year in a row, I moderated the CEF Industry Roundtable, but this time, we shook it up a bit. In prior years, the panel's focus had been on the current state of closed-end funds. This year, the panelists and I decided to focus instead on income and education.

Income, after all, was the shadow agenda of the conference. There were several presentations on master limited partnerships and senior loans. One panel later in the afternoon was actually titled "Investing for Yield Through Exchange Traded Products." So it wasn't a stretch to focus our own panel on the need for income, how most modern CEFs have been built to provide income, and the role that the industry itself must play in better educating advisors and investors about the benefits and risks of CEFs.

The increasing need for income has become somewhat commonplace for investors in the United States. Therefore, I asked Bob Bush of Calamos Investments to walk us through his article that addressed the yawning income deficit facing those approaching retirement. Bob Ionescu of Legg Mason followed with a brief overview of his firm's recent global survey of affluent investors that highlighted the need for income across the developed world. So income isn't just a topic of interest, it's a true need for older investors if they wish to maintain their standard of living in retirement.

What's peculiar is that CEFs have long been available for investors as a means to boost income. Jonathon Isaac of Eaton Vance led the audience through a quick history of closed-end funds, pointing out that the vehicle has been around for about 130 years. It's no fly-by-night gimmick dreamed up to address a pressing need. The first group of so-called modern CEFs came out in the late 1980s in the form of municipal-bond CEFs. Over time, as the industry learned how to provide income via non-fixed-income-related asset classes, more CEFs were launched. Today, it's difficult to find an asset class that doesn't have a closed-end fund investment vehicle that provides a higher level of income than mutual funds or ETFs with similar underlying portfolios.

So if CEFs are the investment vehicle best suited to provide much-needed income, why do we even need to have this discussion? Anne Kritzmire of Nuveen Investments pointed to the relative complexity of CEFs. Not only do most CEFs employ leverage, but compared with mutual funds--about which advisors are highly educated--there is the importance of understanding premiums and discounts, sources of distributions, how to properly buy and sell the securities (limit orders), and so on. Time and again, advisors and investors who don't fully understand the product end up getting burned and forswearing further use of CEFs.

It seems, then, that there is an overarching need for education and advocacy. At Morningstar, we do our best to provide educational materials and interesting articles for our readers. But not everyone reads our materials or even visits our site. We can't enlighten investors on our own, and we don't. All four of my panelists work at firms that we consider to be at the forefront of providing good educational materials to CEF investors on their websites.

There seems to be a determined push on the part of the top players in the CEF industry to do more in terms of education. After all, a highly educated investor who understands the risks and benefits of investing in CEFs is likely to be a better shareholder for them. Furthermore, these CEF sponsors have products available to address the pressing income needs of investors, so it makes sense that they would do more to advocate for CEFs on the education side.

After we discussed the need for fund families to do even more to support their funds in the secondary market--as opposed to some fund families who seem to launch their CEF IPO and then do the absolute minimum in terms of product management--we had time to take one question from the audience. I mention this because it says loads about a real impediment to tapping CEFs' provision of income. A gentleman in the audience took to the microphone, pounded the table about the benefits of state municipal-bond CEFs, and then identified the industry's real Achilles' heel when it comes to better educating investors: Brokers paid on commission have a small, one-time incentive--aside from the IPO--to invest their clients' money in CEFs compared with the commission streams they can reap by investing in lower-yielding mutual funds.

That was an excellent point, and an issue much larger than our panel could address.

I believe that most advisors and brokers truly have their clients' benefits in mind, but perhaps I'm naive. Industry executives understand that they're never going to have 100% acceptance of CEFs as the investment vehicle of choice when it comes to providing income. However, increasing advocacy and education should make the CEF universe more efficient, which would be good for executives and investors alike.

There's really no getting around the increasing need for income in a low-rate environment and the ability of CEFs to provide higher levels of income. The industry's increased involvement in advocating for and educating about CEFs will be the catalysts that go a long way toward resolving the income issue.

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

Hear Morningstar CEF Expert at Upcoming Forum
Join Morningstar on Wednesday, May 22, 2013, at The Advisor Summit on Closed-End Funds in New York City. The Closed-End Fund Association is sponsoring the event. Mike Taggart, head of U.S. closed-end fund research, will be presenting a panel on "How to Analyze Closed-End Fund Data." Click here for the agenda and registration information. 

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