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By Jeremy Glaser and Cara Esser, CFA | 03-05-2013 02:00 PM

How to Keep Tabs on Your CEF Parents

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.

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