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Should You Ditch These Funds for Their Cousins?

Investors might want to consider using another fund vehicle for access to these three strategies.

Steven Pikelny, 05/28/2013

Fund investing can be a complex process that includes finding the right management team, portfolio characteristics, track record, and parent company. But even after all this, there is one last step: Always check to see whether a similar fund exists with a better value proposition. Among nearly identical funds run by the same management team, for instance, there may be a better vehicle available. With this in mind, let's take a look at a few lateral moves open to fund investors.

Western Asset Emerging Markets Debt SEMDX
For investors of Western Asset Emerging Markets Debt, rotating into one of the three closed-end fund versions of the same strategy may make sense. These funds are all managed by the same team at Western Asset and have nearly identical portfolios. In general, the funds focus on U.S. dollar-denominated emerging-markets sovereign debt (roughly 60% of assets), though they also have some local currency sovereign (10%) and external currency corporate (26%) debt. While the mutual fund had a trailing 12-month yield of 4.5%, the (unleveraged) CEFs Western Asset Emerging Markets Income EMD, Western Asset Emerging Markets Debt ESD, and Western Asset Worldwide Income SBW each earned 5.8%, 5.3%, and 6.1% at share price, respectively. However, total returns for the four funds are typically very similar. The mutual fund returned an annualized 10.6% and 9.1% over trailing three- and five-year periods. For these periods, the three CEFs logged performance within 60 basis points of these numbers (Western Asset Emerging Markets Debt was slightly higher, Western Asset Worldwide Income slightly lower, and Western Asset Emerging Markets Income about the same).

Beyond the higher distributions, the three CEFs may offer other slight advantages. While the institutional and A share classes of the mutual fund charge 0.95% and 1.25%, respectively, Western Asset Emerging Markets Income charges 1.25%, Western Asset Emerging Markets Debt 1.12%, and Western Asset Worldwide Income 1.38%. What makes the CEFs attractive is their respective discounts: 1.9% for Western Asset Emerging Markets Income, 1.0% for Western Asset Emerging Markets Debt, and 4.7% for Western Asset Worldwide Income. Those discounts increase the CEFs' distribution rates at share price by 13 basis points for Western Asset Emerging Markets Income, 8 basis points for Western Asset Emerging Markets Debt, and 29 basis points for Western Asset Worldwide Income. While the added benefit of buying into these funds at a discount might not be strong enough to make them attractive compared with the mutual fund's institutional share class, they still present a good opportunity to investors in other share classes.

Templeton Global Bond TPINX
Why would anyone want to ditch the Gold-rated Templeton Global Bond? With a superb management team and a stellar track record, all for a 0.89% expense ratio, what's not to like? The fund is an excellent choice for world bond exposure, in our opinion, but investors might want to consider the CEF equivalent, Templeton Global Income GIM. Both funds are managed by Michael Hasenstab and generally have the similar country allocations. There are some differences in the funds' currency exposure: Templeton Global Income has roughly a third of assets denominated in U.S. dollars, various Asian currencies, and various Latin American currencies. In contrast, Templeton Global Bond is more U.S. dollar-heavy, with half of assets denominated in the greenback, about 20% denominated in Latin American currencies, and about a third in Asian currencies. Both funds recently had short positions on the Japanese yen and the euro. Although Templeton Global Income uses no leverage, it has outperformed Templeton Global Bond on a net asset value basis over trailing one-, three-, and five year periods. Templeton Global Bond returned an annualized 16.0%, 8.5%, and 9.5% over these periods, while the CEF returned 18.7%, 10.9%, and 11.7%.

Despite some slight differences, Templeton Global Income charges a slightly lower total expense ratio of 0.75%. However, Templeton Global Bond investors might want to put the CEF on their watchlist rather than switching right away--it typically trades at a premium (4.6% on average over the last three years).

Putnam Diversified Income PDINX
There are plenty of reasons to avoid the Negative-rated Putnam Diversified Income, such as its spotty and highly volatile performance and high-risk portfolio. But for investors who are nevertheless attracted to its unconstrained approach, low fees, exposure to nonagency mortgage-backed securities, and unique duration positioning (negative 0.54 years as of April 30), there's an additional reason to avoid Putnam Diversified Income: Its CEF cousin Putnam Premier Income PPT has a few distinct advantages. The two funds are managed by the same team and sport nearly identical portfolios, but PPT only charges a total expense ratio of 0.88% versus the 0.99% expense ratio and 4% front load on Putnam Diversified Income's A shares. What's more, shares of Putnam Premier Income were recently  trading at an 8.5% discount, giving its distribution rate at share price a 50-basis-point boost. Even investors in Putnam Diversified Income's institutional share class (which charges a 0.74% fee without a load) may find that the CEF's sizable discount more than makes up for the discrepancy.

Another less obvious advantage is Putnam Premier Income's closed capital structure. Both funds invest in nonagency mortgage-backed securities, which present some liquidity risk. However, this is less of a concern, as the CEF is not subject to inflows and outflows. In any case, the difference in capital structure appears to have helped Putnam Premier Income on a net asset value basis in past years. On an absolute basis, the CEF outperformed the open-end fund's A shares over the trailing five-, 10-, and 15-year periods. Adjusting for volatility, the fund had Morningstar Risk-Adjusted Returns comparable to the same share class (after waiving the load).

Switching funds is not something to be taken lightly. Doing so may trigger taxable events that could wipe out the cost savings of moving into a cheaper fund. Investors considering switches will also want to make sure they're comfortable with the differences between their existing fund's structure and risk profile and those of the new fund they're considering.

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Steven Pikelny is a closed-end fund analyst at Morningstar.
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