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Separating the Wheat from the Chaff in Closed-End Funds

Mike Taggart, CFA

Mike Taggart: Separating the wheat from the chaff in closed-end funds. I am Mike Taggart, closed-end fund strategists at Morningstar. With me today is Maury Fertig of Relative Value Partners.

Maury, thanks for joining me.

Maury Fertig: Thank you.

Taggart: Maury your firm invests over half a billion dollars in closed-end funds and ETFs since May of '06. One of your portfolios has posted a 9.5% annualized return. Clearly, your firm has a good process in place. I was hoping you could kind of tell me little bit about the process, walk me through it.

Fertig: Sure, we look at the entire closed-end fund universe. There is about approximately 650 funds in the United States, and we basically screen out some of the funds that are very, very small, and very difficult to invest in, but once you're left with several hundred, what we consider liquid funds, we divide them into various categories, such as national muni fund, taxable corporate bond fund, emerging-markets funds, covered-call funds.

Taggart: So, you are trying to like separate them so you are going to compare apples-to-apples as close as you can?

Fertig: Yeah. So, now we find that it's not that relevant to compare a municipal – a levered municipal bond fund to a taxable or to even an emerging-market bond fund, or an equity strategy fund.

Taggart: Right.

Fertig: So, we try and look at them within their sub-categories and then we score them, based on a number of measures, including what is the z-score? What's the average historical discount? What the…

Taggart: Now the z-score, just so our viewers know? That's the statistical measure, it's the current discount minus the average discount over a certain time period, divided by the standard deviation of the discount over that same time?

Fertig: Right. So, it gives you a numerical, simple way of looking at, if the fund is cheap, if the discount is relatively cheap to where it's been historically.

Also, some of the other aspects, we might look at the, who the manager is? If they have a managed distribution policy, what the overall yield is of the fund, and things like what's the fee structure underlying the funds? Some funds have very nice reasonable fees, and some funds have exorbitant fees, and that also will be one of the inputs in terms of evaluating a portfolio manager.

Taggart: With your process, how much do you take leverage into consideration? How much do you take distribution rate into consideration?

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Fertig: We have a preference for unlevered funds, because of their durability in the event of a severe test stress in the market, such as what we saw in 2008. And the prospect of deleveraging the fund is a very – is almost catastrophic when that has to happen.

Taggart: When they have to happen, I mean, that capital just goes away. [My colleague] Cara and I like to say that that gets rid of one of the aspects of closed-end funds: They are always closed to shareholder redemptions, but they are not close to capital call redemptions.

Fertig: Exactly. So you want to be mindful of the funds with leverage and that is part of our scoring system. As far as your distribution rate, the market definitely has a preference for higher distribution rates rather than lower distribution rates. So when you consider all the factors, that's generally a positive, as well. Obviously, for any investor a fund that's trading at a premium to its net asset value and is distributing a managed distribution process, is actually returning capital to you at a lower price than you are paying, then you never want to be involved in the ownership of those.

Taggart: More often and not that's the case. It's often that's a conundrum for most people, because they say, return of capital, they must be trading at a steep discount. No, they are usually trading at a steep premium.

So, well that process seems to work very well for you. As I said, your return metrics--9.5%, since May '06--very handily beating the equity market. How much do you typically put like into equities versus bonds? How do you look at sectors?

Fertig: Sure. Great question. That's our absolute return strategy that you are referring to. And there we're just trying to generate a positive number better than cash, and the baseline in that portfolio is half equities, half fixed income, but what we found is, when the value shift in terms of, when the equity funds are much more attractive on a relative basis to the fixed income funds, we'll tilt the portfolio that way.

So, for example, now the average fixed income fund is actually trading at a slight premium and the equity funds are still trading at an average discount. So there are definitely more equity funds that are in our buy zone, so to speak, these days than bond funds. So right now we are about two-thirds, one-third equity over fixed income in that particular strategy.

Taggart: Again, taking advantage of those relative values out there in closed end funds – it's one of the biggest attractions of closed end funds,

Fertig: Absolutely.

Taggart: Well, thank you for joining me today.

Fertig: Thanks for having me.

Taggart: I am Mike Taggart for Morningstar. Thanks for watching.