Wed, 20 Mar 2013
Among the myriad factors at play in a CEF's Parent pillar, investors should pay particularly close attention to a firm's board, management incentives, and culture.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How should closed-end fund investors think about stewardship? I'm here with Cara Esser; she is our closed-end fund analyst. We're going to talk a little bit about this. Cara, thanks for joining me.
Cara Esser: Thanks for having me.
Glaser: So, if you're thinking about investing in a closed-end fund, what are some of the things you should keep in mind about the organization that runs it, about that stewardship?
Esser: So just a little bit of background. The parent grade that we give to every fund that we rate is part of our Morningstar Analyst Rating. So, our rating is based on five pillars, and just for a review, the five pillars are: People, so the people running the fund; Fees; Performance of the fund; the investment strategy [Process]; and the Parent. And so the Parent is just one fifth of the Analyst Rating, but it is an important part of that rating.
Glaser: So, what are some of the attributes that go into that rating?
Esser: We look at a number of different things for the Parent rating. The first would be overall corporate culture, and this is kind of difficult to quantify. But we talk to the managers, we talk to the compliance department, sometimes the analysts at the firm, to just kind of gauge the overall culture that goes into the firm and running the funds. We also want to look at how transparent they are with investors; do they generally make decisions that are shareholder-friendly overall?
The other ones that we look at are a little bit more quantifiable. So we look at manager incentive, so how much are the managers paid, how are they paid, and do the incentives lineup with long-term shareholder performance, like bonuses based on three- and five-year returns over a benchmark? We also look at ownership of the funds that they run. We like to see at least 80% of the firm's managers owning more than $1 million in shares of the funds that they run. However, that's for core holdings, so if it's a noncore holding, we have a lower threshold that we like the managers to meet. We look at fees across the board. We would prefer lower fees, obviously, across the board, and we give each firm a fee-level grade based on the overall firm fee levels on all of the funds that they run.
We also look at the board of directors, so we want to be sure that they are experienced enough to manage the funds. We need to know how many funds they are overseeing and in charge of, how active they are, how often do they meet, do they push back against the managers, and are they actually doing things that are helpful to the shareholders? And finally we look at regulatory history. Mostly, we're just looking to see they don't have any SEC citations or legal issues that are hanging over them.
Glaser: So for CEFs, are there particularly parts of that rating that strike you as more important than maybe for open-end fund investors or ETF investors?
Esser: For closed-end funds, we are especially concerned with the board of directors, because everything that goes on in a closed-end fund goes through the board of directors. So, if you want to fire a manager, the board has to approve it. Changing distribution rates, the board has to approve that. And we often find that boards are either very active or not active at all. So you want to really look and see are they changing distribution rates when they need to be changed? Are they enacting some discount management programs, like share repurchases? Are they generally looking out for the well-being of the shareholders. So, the board of directors is very important.
We also are, obviously, concerned with manager incentives, and very few of the closed-end funds out there meet the $1 million or more manager investment threshold. But we do take into account that oftentimes, they are smaller funds in general and oftentimes are noncore strategies, like a municipal fund or, for example, a preferred share fund. So we wouldn't necessarily require $1 million or more in all of the funds that these fund managers run, but we do want to see a good amount of share ownership. And we also look across the strategy in general. If they run 10 municipal funds and they don't own $1 million in one fund, but they own $1 million across the strategy, we would think that that would be appropriate, as well.
And then finally, corporate culture is, again, hard to quantify, but there are a lot of very small closed-end fund shops out there that people aren't really familiar with. So, as an investor, what you can do is go to the website, see how transparent they are, how often are they giving you portfolio data, and how often are they communicating with shareholders about strategy and about overall market outlooks. Some firms have started to give quarterly portfolio calls, so anybody can call in and listen and hear what they have to say about what they are doing with the portfolio and overall market outlook. So those kinds of things generally indicate a positive corporate culture.
Glaser: Looking across the CEF universe, what are some of the parents that you think are doing an exemplary job, and what are some that you think are maybe missing the mark?
Esser: One of our favorite closed-end fund parents is Nuveen Investments. They basically do everything right. They have a strong corporate culture; they're very transparent. They have a good education center on their website, just about general closed-end fund information. If you don't know a lot about closed-end funds, you can go there and learn just the basics. They provide a lot of information to shareholders, and they do it very frequently.
Some of the firms that we are less excited about, we don't really have any that are negatively rated, but we have some neutrally rated parent firms. One, for example, would be Eaton Vance, and it's a perfectly fine firm. But they don't do anything exemplary. We don't think that they are out there being exceptionally shareholder-friendly. Fees are average; manager ownership is average. Everything about it is very average. So it's nothing bad, but it's nothing exceptionally well.
Glaser: Cara, thanks for your thoughts on the stewardship today.
Glaser: For Morningstar, I am Jeremy Glaser.