Dea Markova: I'm here at the Morningstar Investment Conference, and joining me is Mike Taggart, he is Director of Closed-End Fund Research for Morningstar, and interrupted his honeymoon to come and talk to us. So Mike, congratulations on your marriage and thank you for being here.
Mike Taggart: Thanks for having me.
Markova: My first question to you would be: CEF discounts, they are something that can scare investors away or present an opportunity. Can you expand on that point you just made?
Taggart: Sure. So closed-end funds have a share price that’s set by the market, and then they have the net asset value, which is based on the value of the underlying holdings in the portfolio. Now when the share price is trading below the net asset value, the fund is said to be trading at a discount to the net asset value, and when they're trading above, they are said to be trading at a premium.
A lot of times people like closed-end funds because they feel that “Hey, I can buy this net asset value for less than what it's actually worth on the market.” Now, I mean, I think you have to be very careful; it is definitely a benefit and a reason why people like to use closed-end funds, but there is nothing in the play book that says that a share price has to go back up to the net asset value. And also over the course of a market cycle, another way for a discount to narrow is for the net asset value to fall to the share price. So it's an interesting feature of them for sure. If you know how to use them a little more sophisticatedly and look at discounts maybe on a relative basis—relative to what their average historical discount has been—it’s a much more sophisticated way to do it. But it is a bit of a fun way, a fun thing, and it drives people, and I would just say be aware that if you are investing in closed-end funds only because they provide this discount, it's not a reason to be investing in closed-end funds.
Markova: Okay. Speaking of reasons why we should invest in closed-end funds, you mentioned that there are certain sectors or geographies that lend themselves better to this closed-end fund structure. Can you say more about this?
Taggart: Well, you know, when you buy a closed-end fund you get active management, just like you would in an open end—an OIEC. And the closed-end, the fact that it's closed, means that it's closed to new capital. So you don’t have the redemptions from shareholders who are leaving. You don’t have to create new shares and have this inflow of capital that you now have to invest as a fund manager. So I think that if you are looking to invest in the emerging markets, it's very suitable to put an emerging markets investment in a closed-end fund structure. Anything that’s a little illiquid or more volatile, I think belongs more appropriately in a closed-end fund structure.
When you look at equities, even domestic equities, value versus growth, or however you want to split it up, right, but more value-oriented equities should be, I think, there’s a great case to be made for if you are looking to invest in value-oriented equities to put those in a closed-end fund structure.
Markova: Right.
Taggart: So that’s just my opinion but when I look at the performance and look at different things, and then the things that like maybe a value-oriented manager would gripe about maybe, I think that most of that could be resolved if it was in a closed-end fund.
Markova: Right. Another one of the benefits for CEFs that you mentioned is the fact that they have a Board of Directors. Can you talk about a little bit on why that’s a good thing, and also whether these Boards are fulfilling their duties and really delivering these benefits to investors?
Taggart: Well, you know, I think they are, because the duty of any Board of Directors is a fiduciary duty to the underlying – to the shareholders. And what you have here in the U.K. is you have an independent Board of Directors, so it's independent of the asset manager. And although it doesn’t happen very often, the Board of Directors can fire the asset management firm that it has hired to manage the fund's assets. You may think, well, it doesn’t really happen very often, well it almost never happens in the U.S., and then the reason is because we don’t have fully truly independent Boards. And the other thing about over here is that the Directors typically own a large number of shares in the closed-end fund, and that’s really good as well because you want to invest alongside Directors, who have an interest in the fund as well as you do.
Markova: Right. Yeah, that speaks a lot. So one of the things you mentioned is that regardless of all these benefits, closed-end funds are not as popular as open-end funds. And the U.K. is having the RDR change coming along—do you think that that move to a fee-based model [of financial advice] might make CEFs more popular?
Taggart: Well, I do think that it could have that knock on effect there, because right now, I mean, the incentive here and in the States is to go with, I think, the fees of making it more popular. Because with the closed-end fund you're just getting the brokerage commission and that’s it, you are done and over with. And some people can say, “Well, yeah, but that’s good because then there is no ongoing expense for the shareholder.” I think that the benefits of the closed-end fund structure actually outweigh that, and I think that a lot of people, not only advisers, but also individual investors are doing themselves and their clients a disservice by not looking at closed-end funds, and not considering their benefits. And not because necessarily they're not being incentivised to do so, but just because there are so few closed-end funds relative to the larger universe that it's very easy to overlook them. And then because they are so few, it's very difficult to create a paradigm or a mental model through which to figure out which closed-end fund should I invest in, which one’s a good one. I think with RDR you are going to have, we're going to have more education about closed-end funds, and it's going to actually be imperative to look at—be vehicle agnostic as to how you're going to get that asset allocation exposure. I think it's [RDR] a really good thing for closed-end funds.
Markova: Right, that definitely sounds great for closed-end funds. So on a last note, just in terms of, like you say, picking the right closed-end fund, what are kind of the key metrics that investors can look at and what are some pitfalls to avoid?
Taggart: I think that, as I mentioned earlier, a lot of people get excited about closed-end funds because of the discount. Almost like “I can buy a £1-worth of assets for 85 pence!” Yeah, you can, but there is nothing that says that all of a sudden that 85 pence is going to become worth £1. So I think that’s actually a bad reason to invest.
You want to invest in a closed-end fund for the same reason you want to invest in an open-end fund: It's a good active manager; you get the diversification that having a portfolio of holdings brings you; and, you know, the fact that it has a discount should be secondary, if anything. It's almost like once you find a fund, if it happens to be trading at a discount, good for you; if not, oh well. And the other thing is the leverage, a lot of funds use leverage, gearing, and when you're using gearing, you get benefits such as maybe higher income that the fund can produce for its common shareholders, but what comes along with that is increased volatility in the net asset value and the share price. So I always like to warn people that if you are going to invest in these that do have some gearing, be prepared for – take a long term view, but be prepared for the volatility to be magnified. Now, over a long period of time, our studies and other studies have shown over a five-year stretch volatility works to – the gearing works to the investor's advantage, but it's really important to keep your client’s focus on the long term.
Markova: Mike, thank you for your time.
Taggart: Thanks for having me.
