Morningstar hosted its first-ever ETF Invest Conference last week in Chicago. I attended the first day of the conference in the hope that I would find a few nuggets of wisdom to store away and to apply to closed-end fund, or CEF, analysis. The day kicked off with Dan Farley, global head of investments at State Street Global Advisors, presenting his outlook for the economy and markets. I was struck at how cohesive his argument for a slow, shallow recovery was. You can read my blog posting of Farley's remarks here, or view a video interview of Farley here.
For me, though, the session most apropos to CEF investors (or investment trusts or investment companies investors, as they are more commonly referred to in the UK) came at the end of the day, in an interview Don Phillips, Morningstar's president of fund research (and my boss's boss) had with Lee Kranefuss, former global CEO of iShares. Kranefuss is credited with creating iShares as an ETF powerhouse, growing their U.S. business from under $2 billion to over $500 billion in customer assets from 2000 to 2010. You can read a blog summary of their interview here.
Education
Three items struck me, in particular. First, Phillips hit on the theme of investor education a few times during the discussion. Because ETFs were so new when Kranefuss' team started significantly broadening the product offering, investors didn't even really understand what they were. So, iShares made it a point of educating investors about ETFs. The point wasn't to market iShares offerings in the guise of education. The point was to explain how ETFs actually work and their structural advantages over mutual funds. When asked if he ever was concerned that his marketing dollars were being spent on also making his competitors' products more understandable to investors, Kranefuss responded that the idea was to make the pie larger and to have faith that his firm would have a large piece of this growing pie.
I believe that education is crucial for all investments, not just newly launched investment products. CEFs have been around, in one shape or another, since the late 1800s in both the United States and the United Kingdom. Because of their longevity, it's easy to make the assumption that everything there is to know about them has already been explored. We also take comfort in knowing that they are regulated but that hasn’t stopped problems in the past, particularly when regulation was less stringent. But consider that academics can't even explain the discount/premium phenomenon.. As investors, there are several issues that must be continuously considered before we put our money to work in CEFs. Building a CEF investment framework is a tough task. Education--ongoing education--about the product as a whole and a prospective CEF investment in particular is crucial to developing such a framework. My colleague Cara Scatizzi and I in the US have already been very fortunate to have had CEF industry veterans help us develop our own understanding of how these investment vehicles work, and our innate curiosity always has us asking new questions. Our hope is that we can pass what we learn onto our readers. There is no diploma for attaining investment knowledge; there is always more to learn to make us even better investors.
Information Asymmetry
The second item that struck me was a comment Kranefuss made regarding information asymmetry. He referred to it as information arbitrage -- the knowledge of the vendor versus the ignorance of the buyer. Institutional market participants have knowledge. They have analysts on staff, and they can hire consultants. Individual investors and advisers, to a degree, are left on their own. They have to figure it out on their own. Most advisers devote an inordinate amount of time educating themselves about investments that are appropriate for their clients' money.
Reputation Risk
Finally, the third comment I am still dwelling on from this interview has to do with reputation risk. Phillips pointed out that, with traditional mutual funds, the largest players tend to do the right thing for investors. This isn't to say that they have no issues; but, for example, none of the big players were involved in the mutual fund market-timing scandal early last decade. It was the smaller players who harmed the industry's reputation. Because the large players, by definition, dominate the industry, their reputation tends to be very important to them. Kranefuss chimed in that one ETF could have a problem, and the headlines the next day would read that ETFs (as a whole) have a problem.
How true this is for CEFs! Investors' experiences with one CEF affects how they will view all CEFs. I have received emails from advisers and individual investors, lamenting a poor investment experience with a CEF and stating that all CEFs are bad investments. Similar to Phillips' view, I believe that the larger CEF players--for the most part--are doing an honest job, trying to make money for their investors. And I'd even be willing to argue that most of the smaller shops do likewise. My experience in talking with CEF executives is that the vast majority, almost all, of them take pride in their work and in their CEFs. They strive to achieve good total returns for their investors.
But there are a few fund families that have repeatedly obfuscated their strategies, their expenses, or have otherwise engaged in nefarious dealings. These are the fund families that, looking out only for their own interests, put the entire CEF industry at risk of reputational damage. Their tactics make good fodder for critical articles, but even there the risk is that readers walk away from the article thinking that such criticism applies to all CEFs. Caveat emptor applies to every investment. Yet again, education can help us discern when a CEF looks too good to be true.
