Jeremy Glaser: For Morningstar, I am Jeremy Glaser. It's been a little bit over a year since we launched the Morningstar Analyst Ratings for closed-end funds. I am here with Cara Esser. She is a closed-end funds analyst. We're going to look at some recent changes and how investors can use these ratings.
Cara, thanks for joining me today.
Cara Esser: Thanks for having me.
Glaser: We've had a few questions about the differences between the Analyst Ratings. There are Gold, Silver, and Bronze ratings for closed-end funds versus the ones for open-end funds. Are they measuring something different? How should investors think about those two different ratings?
Esser: They are essentially the same rating. We use the same five pillars; people, process, performance, price, and parent. Also for close-end funds we look at the different things that don't happen in an open-end fund, like a distribution rate and leverage.
One thing that the Analyst Rating does not measure in a close-end fund is valuation. So, we're not looking at the discounted premium. It's not a buy-and-sell signal necessarily for a close-end fund because we're looking at the underlying performance of the portfolio, the net asset value, not the share price.
Glaser: So, how do you decide when it's time to change a rating? What are some of the factors that go into an upgrade or a downgrade?
Esser: We look at ratings about twice a year for our funds. We're updating them. We're updating the text. We're talking to managers, and that's generally when we will look at changing the rating for a fund if it needs to be changed. But if there is something that happens in the middle of an update process that potentially requires a ratings change, we'll do it then, too.
Glaser: So, can you talk a little bit some of the recent changes?
Esser: Sure. We recently upgraded two funds; one is the Zweig Fund, ticker ZF, and one is the Zweig Total Return Fund, ticker ZTR. So, they are very similar funds, but we didn't like these funds for a lot of reasons. They had unsustainable distribution policies. The discounts were wide all the time. And we didn't feel that the board of directors was doing anything, lobbying on the behalf of shareholders to improve the long-term performance of these funds.
So, in the beginning part of 2012, so about a year ago, the board of directors made a number of changes that we thought were very positive for the funds, including a discount-management program. They lowered the distribution rates, and they've allowed the managers to hold less cash in the portfolio, which should help--as long as they're investing it properly--improve the future performance of the fund. So, for these reasons we actually raised the fund's ratings from Negative to Neutral.
Glaser: Are there any cases where you've lowered ratings recently?
Esser: Sure. We've lowered ratings on funds often times based on distribution policy changes that we find to be inappropriate going forward and also for long-term performance discrepancies that we don't like. So, we're not constantly looking back at historical performance, but obviously, that's a guide for future performance. Let's say, a strong outperformer has underperformed over maybe a year or two years or three years, we want to look at why it's underperforming. Is it a strategy change? Is it a management change that is going to impact the future performance? So, those are some of the reasons why we would downgrade a fund for performance. [Another reason is if there is a] distribution change. Maybe they raise the distribution, but we didn't think that it was appropriate for the strategy to increase the distribution and we maybe don't think it's sustainable going forward.
Glaser: What's the best way for investors to use these ratings then? If I hold a fund, and it gets downgraded, should I be running out to sell it, or is it more of a nuanced picture?
Esser: It's much more nuanced, especially when you look at the closed-end funds because, like I said, we're not looking at valuation here. We're looking at the net asset value, the underlying manager performance of the funds going forward. So, a downgrade that results from, let's say, a distribution policy change may not be a sell for an investor if you aren't holding that fund for income, for example.
You want to understand why you're holding the fund, why did it get upgraded or downgraded. Does that change [your reasons to hold] the fund, and does it impact your performance going forward? You also want to look at valuation. So, an upgrade doesn't necessarily mean that you should go out and buy the fund because it might be overvalued at the time that we upgraded the fund. It might be one you want to put on a watchlist and maybe check to see if the valuation becomes more advantageous in the future.
Glaser: Cara, thanks for being with us today.
Glaser: For Morningstar, I am Jeremy Glaser.