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By Jason Stipp | 02-25-2011 12:01 PM

Tour Our CEF Solution Center

Morningstar's Mike Taggart highlights our new closed-end fund slideshows on CEFs versus other funds, discounts and premiums, distributions, leverage, and more.

Jason Stipp: I am Jason Stipp for Morningstar. We've launched a Closed-End Funds Solution Center as part of our ongoing closed-end fund research rollout.

Here with me to talk about what you can find in Solution Center is closed-end fund strategist, Mike Taggart.

Thanks for joining me, Mike.

Mike Taggart: Thanks for having me.

Stipp: So the solution center is an educational center for investors to learn the ABCs all the way to more advanced concepts on closed-end funds.

It's a slideshow format. There are a variety of things in here; I just wanted to touch on a few of them. The first one being I think a question that a lot of investors probably have even if they want to admit it, what exactly is a closed-end fund?

Taggart: It's a great question, actually. So a closed-end fund is kind of like a mutual fund, and it's kind of like a stock. So, like a mutual fund, it has money that it invests in a portfolio of securities, but whereas an open-end fund stands ready to buy back and to create shares everyday at net asset value, a closed-end fund is called "closed-end" because the ends are closed. The capital doesn't flow in or flow out on a daily basis, sometimes they will have corporate actions where they will do things, but for the most part, it's closed.

So, like a stock, they'll have an IPO. They'll raise capital. And then with that capital they invest in a portfolio. Now, as a result, the reason it's closed, the shares trade on an exchange. So you get intraday ability to buy or sell those shares, but what that sets up is, the portfolio with the closed capital has a net asset value, and the share price trades independently of that net asset value. That sets up a lot of unique attributes like a discount and premium.

Because it's closed, and they don't have to stand ready and have capital on the side, they can invest in more illiquid securities. They can actually issue debt; they can issue preferred shares. So the structure itself, closed capital from inflows and outflows, but they have a lot of unique attributes from this.

Stipp: That also sounds like it's very similar to an exchange-traded fund, as both are traded on an exchange and they can have an underlying net asset value plus the market price because they are traded on that exchange. What's the differentiating factor between ETFs and closed-end funds?

Taggart: For the most part the biggest difference is the creation and redemption feature with exchange-traded funds. So a lot of people actually who know about ETFs, they think closed-end funds are ETFs. In the industry they are both known as exchange-traded products, but the ETFs have that creation and redemption feature that market makers can utilize, that keeps the discount and the premium, typically, very tight with the underlying net asset value.

Stipp: So the mechanism with the ETFs basically keeps that underlying portfolio value and the market price pretty much in line most cases, whereas the closed-end funds because they don't have that mechanism the discounts and the premiums can be much more persistent.

So because of that, how should I think about the discounts and the premiums? This is one of the things you cover in the course. It seems like it's always good to buy at a discount, but it's a little more complicated than that, right?

Taggart: Absolutely. It's very complicated. But at the end of the day, all investors need to pay attention to is the share price that they buy the closed-end fund at and the subsequent total return. That's going to determine if they are generating any economic value from this investment.

A lot of people like to look at a closed-end fund [that has a discount], and they say, well I can buy a $1 worth assets for $0.85, right? They can, but the presumption there is that the $0.85 is going to eventfully go up to the dollar of the net asset value--and that's not necessarily the case.

The net asset value is going to move around based on the security selection of the portfolio managers, and once you are in the fund, if you're thinking you're going to make money by the discount narrowing, what you need is that net asset value to either stay the same or increase, and then have that discount narrow, and that's the way you'll make it. But a discount can also narrow with the net asset value falling to the share price that you bought it at--that will narrow the discount. And the worst case scenario is if the net asset value falls below where you bought the share price, more than likely that share price isn't going to be staying at a premium at that point.

Stipp: So, certainly a lot more to look into than just that discount that the closed-end fund might be selling at. Those discounts can be persistent, but they can also change, but it's more than just supposedly paying that $0.85 for the $1 worth of assets?

Taggart: Absolutely, and that's what we call an absolute discount. Another way to look at these are relative discounts and premiums. So the way we look at it, and what we call the relative discounts and premiums is relative to where its historic discount or premium has been for that individual fund, but you can also look at it relative to the broader universe of closed-end funds, relative to other closed-end funds that have similar investment strategies. There are all different sorts of ways to do it, but for now in the Solution Center, what we walk through is finding "good bargains" by looking at the relative discount and premium.

Stipp: So very important to put that into context. Another thing that you cover, Mike, is distribution, and I know that distributions are an important thing for a lot of investors right now, especially the income-seeking investors. What do they need to know at a very high level about examining the distribution of a closed-end fund?

Taggart: The distribution of a closed-end fund, there are two primary things. The first thing is that you need to know what the source of that distribution is, and there are four potential sources. There is the income that it would receive from interest payments that it receives on its holdings. There is dividend income. Both of those are known as net investment income.

Then there is realized capital gains and then there is return of capital. Return of capital itself can have different levels, but if it's destructive return of capital, their total return is going to be blown out of the water. We always stress, you need to look at what the total return of your fund is.

The second thing that's important is that if you have a distribution rate compared to the net asset value that's extremely high, you have to ask yourself, well how is this portfolio going to generate that high of return to actually make that I am getting an economic return and not just a return of capital. So that's one of the biggest things when you looking at the sustainability of the distribution is to compare it to the net asset value.

Stipp: So very important to see where it's coming from and then to really try to gauge how sustainable is that? Will that payout, that distribution, be able to be maintained.

Last thing, Mike, that I think is one of the really defining characteristics of closed-end funds is the leverage. What will you learn about leverage in the Solution Center?

Taggart: In the Solution Center, we talk about the different types of leverage, and how leverage works. Leverage has a good side, which is that these funds can issue debt, they can issue preferred shares. They also can leverage the actual holdings within the portfolio to gain some sort of economic leverage. But the end result on the positive side is that this will let them bring in more income for the common shareholders from the underlying portfolio.

But on the downside it does increase volatility of the net asset value returns, which in turn tends to bleed over into the volatility of the share price returns, and lot of investors, they'll get into a fund and its levered, and they didn't know they signed up for a rollercoaster ride.

But I would also caution that leverage isn't necessarily just scary, right. The leverage levels are regulated by the Investment Company Act of 1940. The typical closed-end levered fund has an additional $0.30 for every $1 of net assets, so this isn't a Bear Stearns or Lehman Brothers situation. It's typically very, I'd say, modest leverage, but that's not to downplay the volatility that's going to come along with investing in these.

Stipp: All right, Mike, it sounds like some great topics and some very important educational content on closed-end funds. Thanks for joining me today.

Taggart: Thanks for having me.

Stipp: For Morningstar I am Jason Stipp. Thanks for watching.

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