1. How did investors do if they had delayed their entry into the fund post IPO?
2. Are there certain time periods in which the CEF structure tends to do better than a peer ETF? This is also an attempt to take the market movements out of the results and focus on the structural differences in owning a CEF vs. an ETF or open-end fund.

To begin, we selected potential entry points post-IPO. They were (in calendar days): on the IPO date, 1 week, 45 days, 90 days, 180 days, 270 days and 1 year post-IPO. The reason for these entry points was simply to provide points that we could easily remember going forward if the study proved enlightening.

To test these entry points, we examined the returns of each of the funds exactly 2 years post-IPO if the investor had entered at each of the above-mentioned dates (imagine standing two years down the line from the IPO date and looking back to each of these entry points and entering then). Next, we netted out the returns of the market to isolate the potential “alpha” that these funds provided. To do this, we matched comparable ETF’s for each type of fund and subtracted out the returns from the same dates that we were examining in the CEF. This way, we could see the actual effects and performance of the fund, and possibly the market forces on the fund on and after the IPO date.

We examined several types of CEF’s. The categories of funds we studied were: US equity, global equity, US REIT, International REIT, MLP, municipal bond, junk bond and senior loan bond. We had to find CEF sectors that had tracking ETFs available for a two year period with enough funds to make the comparison about the structure vs. the individual fund results. We used a 20 year look back because about 70% of funds were IPO’ed  beginning in March 1993. In total we examined 51 funds. A full list of funds examined is available upon request.

For the given entry points post-IPO, we produced the following percent performance results for the average CEF studied. 

From these results, we see that of these entry points, entering 270 calendar days post-IPO is historically the best day to enter. Before the study, we suspected it would be after the 45 day Greenshoe option and once the fund was able to trade on pure market forces. This is the share over-allotment option that allows underwriters to short sell shares at the offering price and is usually 15% of the IPO’ed number of shares.

We also thought it might be about six months, just before the fund released its first semiannual report.  One of the main reasons we believed it would be between 180 and 365 days was that after the fund has one year of market data and a full annual report, we had noticed – and now proved -  that the CEF typically has more buying interest post 12 months. We believe this stems from the fund having more comparable data for peer analysis and more insight into what the portfolio manager is doing with the fund’s assets.  This higher amount of transparency can easily lead to higher prices vs. NAV and buying before this occurs can improve your returns as long as you are willing to take some added risk in having less transparency.

One other point of note is that we can start to see around 45 days post-IPO that fund-specific returns begin to become positive. This agrees with one of our original hypotheses that the Green Shoe props up the market price, while post Green Shoe, most funds start trading at discounts to NAV.  The IPO commission to bring the stock to market is usually about 4.5% of NAV.

Examining this chart, the next logical step was to find the best day to enter post-IPO, i.e. which day post-IPO, on average, yields the best fund-specific return (we also found the worst day to invest). We did this by calculating the net return (return of the fund minus return of the comparable ETF) of the fund if the investor were to enter the fund at any of the days within the two-year window. We performed this on the same group of funds that we described above. We also calculated the actual average and median returns for the investors if they were to enter in at the best and worst days. The sector-specific results were as follows for each sub group.

As seen in the data above, the results for the actual “best” and “worst” day to purchase the fund in the various sectors can vary.

Conclusion:

We can be wrong in our prediction that CEF IPO’s are never more profitable when purchased at a later date. They key is that we were often correct. It is worth noting the January 2012 DoubleLine Opportunistic Credit Fund (DBL) IPO as an example. 

We recognize that our research focused on the average experience for the average fund and some funds are actually successful at never breaching NAV and holding a premium. The January 27,2012 IPO of DBL is a perfect example.  Its lowest premium has been +4.01% since IPO and has never breached its IPO price of $25 per share.  In our experience it is always possible to find exceptions to the rule or common experience, but investors should be cautious when they buy a CEF IPO. They are far less likely to lose a large amount of capital, but they are unlikely to do better than waiting a few months for better pricing.  One thing we can’t stress enough for CEF investors is doing your homework and being patient and diligent in your research and portfolio management.

Disclosures: This article was researched and written by Andrew Pavloff, a Senior at The College of William and Mary who is currently an extern with Closed-End Fund Advisors and was supervised by John Cole Scott.

The information and statistical data contained herein have been obtained from sources that Closed-End Fund Advisors (CEFA) believes are reliable, but CEFA makes no representation or warranty as to the accuracy or completeness of any such information or data and expressly disclaims any and all liability relating to or resulting from your use of these materials. The information and data contained herein are current only as of the date(s) indicated, and CEFA has no intention, obligation, or duty to update these materials after such date(s). These materials do not constitute an offer to sell or the solicitation of an offer to buy any securities. CEFA may make decisions for its clients in certain of these securities. CEFA and/or their respective officers, employees, and affiliates may at any time hold positions in any of these securities and may from time-to-time purchase or sell such securities.

Closed-end bond funds continue to gain a lot of attention as investors search for yield in a very low interest rate environment. At Closed-End Fund Advisors, we do our best to educate investors on how to avoid some of the big closed-end fund mistakes and this article is an effort to continue that endeavor.

We also are replying to Steven Pikelny’s article last week on the Morningstar “CEF Weekly” comparing Undistributed Net Investment Income (UNII) to body fat – essentially saying that: UNII balances for CEF bond funds are a tax liability, UNII is irrelevant for municipal funds and that the UNII trend “is a functionally useless metric, and muddles the overall point.” I have to whole heartily disagree with this statement. We suggest you read his article in order for ours to make sense.

Current Discount Levels and Tends

Discount and premiums exist at varying levels for individual funds in major CEF groupings, like Taxable Bond funds and Municipal Bond Funds. However, tracking the trend movements on a grouping helps to identify investor and market trends that are being applied across the closed-end fund sector vs. NAV movements, which act on more traditional market forces and reasons.

We give a one-year look back (left) at discounts for the two main bond CEF groupings which we believe demonstrates investor perceptions and interest in the various CEF options for their bond portfolio exposures. The trends that Municipal and Taxable CEFs follow are often significantly different.

UNII Trend and Earnings Trend

CEFA has developed UNII Trend and Earning Trend as data points in our weekly CEF Universe Data Service, a tool that we find crucial in managing our client bond fund positions. With the current challenge of owning bond funds at near-all-time-low interest rate levels, we feel it is important to do two things for bond fund exposure: 1. Doing what we can to own funds that are unlikely to cut their dividend levels (maintaining pay-outs to clients) and 2. Swapping funds over time on relative value (trying to grow principal above NAV movements). We believe this is the only way to keep your head above water over the next 5-10 years with bond exposure due to the almost inevitable interest rate increasing environment. Does anyone think rates will be the same or lower in 2018?

• We hope to clarify where we believe UNII can be misused
• Explain why UNII and Earnings Trend should both be considered in concert with Earnings Coverage ratios in reviewing a bond CEF’s dividend risk
• That UNII levels show clear trends over time that can help make investment decisions for bond funds.
• Return of Capital (ROC) is barely prevalent in bond CEFs.

The CEFU service is the source of all closed-end fund data discussed in this article unless otherwise noted.

We believe Morningstar has done a great job at expanding closed-end fund coverage for the benefit of investors and investment professionals alike over the past few years, and are glad to see three internal analysts write regularly on the fund structure. This week, I think Steven wrote a nice article on how to calculate future tax liability in a CEF. I am also looking forward to sitting on the closed-end fund panel at their 25th Anniversary Investment Conference in June 14th in Chicago.

While I am not completely refuting Steven’s article, I think he missed a few important factors in closed-end fund evaluation and where UNII analysis can get off track. Before we dig deeper into how and why we analyze bond CEFs in a certain way, let’s build off his UNII claim and see where we disagree on it being an important data point. Here is how I agree UNII analysis can have misconceptions or be considered noise:

• UNII is a life-to-date balance for a fund. Funds report GAAP UNII balances, when tax-adjusted UNII levels would be more accurate to determine a “cushion” or “deficit” for the fund. We have confirmed this with portfolio managers of almost every sector in the bond grouping.
• Taxable bond funds need to pay out 98% of its net investment income to avoid excise tax (this keeps UNII growth very small in most cases.).
• Muni bond funds are allowed to pay out less and retain more net investment income (NII) which helps them grow UNII balanced over time.
• The older a fund gets, the higher UNII can go above (typically for muni CEF) and below (typically for taxable bond CEFs) due to the life-to-date nature of the item.
• UNII can be old or stale where, in my opinion, after a few months is almost useless in making portfolio decisions. We prefer UNII data from the previous 1-4 months in order to keep it recent, but also to allow for quarterly updating UNII funds to allow more funds in our potential investment universe.
• UNII is available for equity CEFs but we have yet to see any trends or ways in which this data point is a useful metric for equity CEF analysis.

Review: How Does a Bond CEF Work?

A portfolio manager at a closed-end fund takes fixed or permanent capital raised through an IPO and buys bonds that they feel will make their payments and return investors principal over time. Managers also trade bonds based on mis-pricing of assets and try to net a profit on bond sales and higher future income for shareholders, while managing duration and credit risk in some capacity.

We like to equate bond CEFs to an equity investment that derives its cash flow and value from bonds – but not as a pure bond holding. Because of leverage and market inefficiency the funds are by nature more volatile than many traditional bond investors may be accustomed to experiencing. This is why you should be more risk tolerant to own a CEF and can expect to receive a higher dividend payout.

CEF’s & Leverage

Currently 380 of the 600 U.S. listed closed-end funds are bond focused. This is over 63% of the CEF offerings. There are 342 closed-end bond funds or 90% that utilize leverage in some way shape or form. There are 323 or 85% that utilize more than 10% leverage. These funds borrow at lower rates than they invest and this helps them give shareholders a higher dividend amount per share based on the spread between the cost of leverage and the yield of the bonds in the portfolio. This will eventually need to be watched as interest rates rise when selecting a closed-end bond fund.

Selecting a Closed-End Fund

When reviewing a CEF, we recommend the three pronged approach of balancing: 1. Entry Point Risk, 2. Dividend Confidence and 3. NAV Total Return Performance. We wrote an article covering these in more detail. We find the challenge in balancing which data to prioritize when analyzing a CEF. It is rare one fund in a grouping is best in all three areas.

This is why CEF analysis is still a human-based process vs. simply spreadsheet screening. I relate this to my limited experience in music theory or cooking. You need to understand the rules before you can consistently break or bend the rules and have great success. The best CEF investors know where to break the rules, however, many CEF investors get hurt not following basic principles. Also, as with all investments, there are always going to be surprises and market changing news items that will be hard to plan for in your portfolio.

Investors Dislike Dividend Cuts

We find that investors shy away from funds that have recently cut dividend levels and they end up trading independently from NAV. Since September 2012 there have been 87 dividend cuts in the municipal bond grouping of 100 funds. Some funds have cut more than once, but this is a still a very significant level of cuts. When we reviewed the cuts there were 47 averaging -6% in last fall, and the most recent carnage on March 1 had 33 cuts averaging -7%. This is not an experience investors enjoy from funds in their portfolio.

Our point here is that looking at a closed-end bond fund and determining the likelihood of a dividend cut can help improve total return performance for investors in a way that worrying about a future yet-to-be-realized tax liability muddles the overall point of basic fund analysis.

CEFs trade on factors unrelated to the portfolio manager’s success or investor sentiment to the underlying sector. This is not to say that NAV performance is not important, just not the only factor investors consider. We track this with a 90 day correlation figure between a CEF’s market price and NAV movement. To the left we show the graphical trend since June 2012 for the two bond groupings. Currently taxable bonds have a 54.8% correlation and national muni bond funds have a 59.0% correlation – roughly half-way between their 9 month peak and valley levels.

We reviewed current data on all municipal closed-end funds (3/1/13) and grouped them into three categories: those that 1. Cut Dividend 2. Maintained Dividend or 3. Increased Dividend levels during 2012. The table below should hopefully prove my point.

Investors are currently paying premium for funds that haven’t cut their dividend levels recently and even more for those that raised their monthly payouts. But it is important to note that they are also bidding up CEFs to higher levels in their own discount range over the previous 52 weeks in roughly 10% increments.

This relationship is further confirmed by seeing the fund’s current market prices vs. its 52-week range (Relative Price) in roughly 5% increments. This disconnected trading between performance and fundamental behavior can be seen in the 90 Day Mkt Pr / NAV Correlation with funds that reduced their dividend tracking NAV at about a 73% level (high for a muni bond fund) but only 57%-65% for those that did not pinch investors last year.

UNII Trend – It Does Exist

The Undistributed Net Investment Income (UNII) data point is a balance sheet item equated to an future income “cushion” and in our published interviews with closed-end portfolio managers, we have come to learn that UNII is an important item to consider and one they know investors are watching.

What we did notice was that UNII over time can be well above or below zero and yet it does not result in a dividend change like we would have initially suspected. In fact, it is often at 18%-25% levels in a muni bond fund when they announce cuts in their dividend payments. We also see that when funds–, in this case, muni bond funds– cut dividends they had about 94% of those funds showing a UNII trend of negative (see table below).

Remember though that the trend of UNII needs to be used in conjunction with average earnings coverage and earnings trend can help avoid painful dividend cuts. The date of the UNII is also important. We prefer UNII data that is no more than three months old and our firm has been known to avoid a potential good bond fund in order to wait for updated financials.

It is important to note that UNII is a fraction where the numerator is the cents per share and the denominator is the current dividend yield. This means it trends up when UNII increases or if yield is cut. Cuts have been the driving change from our research in the past few months. To show the importance of UNII trend using real-life data we looked at all the muni bond funds that cut dividend on March 1, 2013 based on previously collected data. The table below also shows the importance of both trends’ analysis to predicting dividend cuts.

Earnings Trend:

This data point is simply looking at if the fund’s average earnings are trending up, down or remaining flat. If coverage is near 100% (95%-105%), we have seen a very high correlation with cuts stemming from down trends. You can see that 97% of the funds that cut their dividend had Earnings Trend “Down” based on the fund’s data.

This actually makes a lot of sense in my opinion, as you can think of a closed-end bond fund like a closed-system of income and payouts. Of course there are fees and costs taken out of the equation, but if a fund is earning less than before and its relative UNII level is trending down (no matter if it is positive or negative) then the board of directors has to 1. Believe the fund’s income will increase over time or 2. Decide to pay-out Return of Capital if they don’t reduce the dividend amount.

It should be noted that other factors to consider are portfolio manager alpha, sector trends (like the direction of interest rates or good credit work in assessing bond default probabilities) and potential activist activity, though this is less likely in a bond fund due to generally narrower discounts. (See this CEF Activism article.)

Return of Capital in Bond Funds:

It was suggested in the other article that investors would rather have RoC payments over dividends classified as income or high UNII levels. We agree that from a purely tax perspective this is true – however RoC dividend are historically low in bond CEFs.

From the data we track on this figure we see only 5%-8% of taxable bond fund dividend levels classified as RoC dividends and for municipal bond CEFs it is even lower at 0%-0.7% of the dividend classifications. We find RoC more common amongst closed-end equity funds. Our data is a 90 day look back on dividend classifications by the fund sponsor.

Conclusion:

I think the comparison between UNII in a closed-end fund and body fat is weak and misses the two main components of total returns: change in the fund’s market price and the paid dividends. Taxation is an important issue; however, after talking with thousands of closed-end fund investors over my twelve year career, my experience shows that many CEFs investors are managing inside a tax-deferred or tax-free account. Therefore, this is less of a pressing issue than Steven Pikelny suggests.

I also know that the perceived value of a CEF and the inefficiencies of the market price almost always trump tax-adjusted performance. This is a measure better suited to open-end fund and exchange-traded investing where you don’t have a different market price vs. NAV. Even though some ETFs can trade off NAV it is less common or significant because of the ability to create units or redeem units of an ETF at the institutional level.

Closed-end bond investors need to track more than one data point and should also remember that data is backward looking and never perfect by definition. Where we feel data is important is to understand where a fund currently lives vs. itself and its peers over time (normal data ranges).

If I told you that 95% of closed-end bond funds that cut their dividend recently showed both UNII and Earning Trends as “Negative” would you want to own a bond fund with negative UNII and Earnings Trend? Does this make you believe that this data is somewhat useful as part of your due diligence? We hope you agree that it does.

We believe closed-end bond funds as a whole have a challenging market ahead. This is both for the underlying bond portfolio and a general reduction in net investment income as leverage costs trend up and reinvested bonds yield less to the portfolio. We think you will fare better with an active approach to monitoring your current CEF positions and trying to avoid fund reducing dividends, as well as buying funds when they are generally cheaper than normal. We are not suggesting this is always going to be easy to do, but we believe your total return prospects are much higher with this perspective.

Disclosures:  The information and statistical data contained herein have been obtained from sources that Closed-End Fund Advisors (CEFA) believes are reliable, but CEFA makes no representation or warranty as to the accuracy or completeness of any such information or data and expressly disclaims any and all liability relating to or resulting from your use of these materials. The information and data contained herein are current only as of the date(s) indicated, and CEFA has no intention, obligation, or duty to update these materials after such date(s). These materials do not constitute an offer to sell or the solicitation of an offer to buy any securities. CEFA may make decisions for its clients in certain of these securities. CEFA and/or their respective officers, employees, and affiliates may at any time hold positions in any of these securities and may from time-to-time purchase or sell such securities.This is not a recommendation to buy or sell any CEF or CEF sector grouping, simply an attempt to educate investors on data and trends we see in the current market environment.

Slides and Audio Reply for CFA San Francisco Keynote.

Slides: http://www.cefadvisors.com/Download/CFA-SFA-2013-0205.pdf

Audio File: http://www.cefadvisors.com/Download/CFA-SFA-2013-0205.WMA

We are happy to share the information we presented last week. Please let us know if you have any questions. 

It was my pleasure to moderate the “Closed-End Fund Activism” panel January 22 in New York at the 4^th Annual Activist Investment conference. The panelists were Andrew Dakos from Bulldog Investors and Art Lipson of Western Investment, both very well known in the world of closed-end fund activism. We were joined by Warren Antler, from AST Fund Solutions as Art was running late and we welcomed his addition as an expert in CEF activism from the proxy solicitation perspective.

Closed-end fund activism is similar to regular corporate activism except it is typically focused solely on both the short and long-term ways to close a significant discount to net asset value (NAV). This is usually done through tender offers, share buy-backs, management changes, adding or removing members of the board of directors, open-ending, or liquidation of the fund at NAV. The goal of the activist investor is to make the extra alpha gained from the narrowing of the discount or shares tendered close to NAV.

Our Panelists:

Andrew Dakos joined Bulldog in 1999 and co-manages the firm’s investment strategy. He has serves as a director for The Mexico Equity & Income Fund. He serves as a Principal of Brooklyn Capital Management, a Registered Investment Adviser and is President of Special Opportunities Fund (SPE).

Art Lipson is the Managing Director of Western Investments. He managed the fixed-income research departments at various Wall Street firms. He created the Lehman Brothers Bond indicies in 1973 and retired from Wall Street in 1985.

Warren Antler is Vice President, CEF Specialist at AST Fund Solutions. He has distributed a monthly dissident tracking and corporate action report on CEFs since 2003.

JCS:  Good afternoon. I have some prepared questions. We also have planned plenty of time for your questions. Do you want to start Warren?

Warren Antler:  In 2012 we’ve had a record amount of fund merges. A lot of those merges were encouraged by activists getting in the fund, and volunteering to merge into a similar fund, a pretty cool idea. Other than that, the discounts are shrinking. Andy and Art are having a hard time finding targets.

Andy Dakos: We advise several private partnerships. My partners, Phil Goldstein and Steve Samuels, founded what ultimately became Bulldog Investors about 20 years ago. The objective of our firm is to identify mispriced assets, under-valued sectors. We’re typically looking for a security trading at a discount to intrinsic value, and then being active in trying to eliminate or at least narrow that discount. We ran about 40 campaigns over the last 15 years. The majority of those were in closed-end funds.

JCS: I’d like to start with a question about closed-end funds being well known for yield and discounts. Is there a discount or distribution yield, range that you search for when deciding how easy it will be to use your activist strategies on closed-end funds?

Andy Dakos:  There’s certainly a discount level that we look at and where we start to get interested. That’s not always an absolute number; it’s in the context of other things, asset class, size of the fund, liquidity of the fund. Probably most important, other than the discount itself, is the shareholder base, who else owns the fund. To the extent that obviously the institutional shareholders may hold a large position in a particular closed-end fund. They’re more likely to vote for somebody that’s coming in and looking to see a narrowing discount vs. the typical individual investor.

There’s only a couple of lead activists in closed-end funds. There are a number of, I’ll call them, passive investors or activist followers. Plus with rates so low, investors are reaching for yield in the CEF space. I don’t know when, but I believe something will happen; municipal rates falling or a credit crisis relapse. Something is going to happen in the market that will lead to selling and wider discounts, certainly premiums will go away.

As for the distribution rate, we’re not interested in what the distribution components will be, whether it’s ordinary income, return of capital, or some combination. That’s not what drives our thesis, in terms of investing and building a position in closed-end funds. It’s really just about the discount.

Art Lipson: With CEFs bond funds, you can create a higher yield in the fixed-income fund than you can get in a regular open-end mutual fund. It’s not so obvious that you’re going to get better performance from an equity fund that’s closed-end than an open-end equity fund because of leverage, just more volatility. Most of the opportunities come from the equity fund area where we are often looking at funds with a lower average payout rate.

JCS: And this has come up since Friday (Jan 18), but Alpine has two funds (AOD)/(AGD), that cut their dividends by 50%; one that was trading previously at about a 10% premium and one at a mild discount. It’s been a pretty rough day for the funds this morning. When funds cut their dividend’s dramatically is this a situation where an activist investor would look into buying shares? (AOD) has an intra-day discount around 16% presently.

Art Lipson: Western reached an agreement with Alpine a year ago, not to attack any of their funds and to always vote with the board. So, we would not be involved in such a situation, but I could imagine other activists would be consider the fund at those discount levels.

JCS: So anybody in the room interested? It may be worth looking at today or tomorrow.

Andy Dakos:  In the situation where you have a discount outlier, whatever is causing the outside discount. A discount that wide sticks out like a sore thumb.

JCS: Let’s shift to some of your own activist experiences. Could you share with the group a Board war story?

Art Lipson: It is our belief that if a fund trades at deep discount to NAV it is a supply and demand issue. Too much supply leads to inadequate  demand and wider discounts.

I’ll contrast the situation, first talking about how one board did a good job, and then I’ll get into how one did a bad job. With Alpine we arranged  a tender for 20% of their shares at 5% discount to NAV. We were a very large holder, as was Bulldog. We signed an agreement with Alpine without filing a 13D notice. We let them know that if they reduced the discount on this fund, we won’t be involved with any of your other funds. So that was a case of management acting productively before it came to a proxy situation.

But last year, we were also involved in a situation on the other side, and this was a fund that was run by Guggenheim. It was a fund half tax-exempt and half equities. They have a staggered board plus have a majority requirement that 50% of all shareholders would have to vote to replace directors. In 2011, we got more votes than their director; however, we didn’t get 51% of all votes, so their director was held over. They just steadfastly refused to negotiate and reach any reasonable resolution terms. The first contest was in July in 2011, and the second contest should have been a year later in 2012. They didn’t have a contest at all in 2012.  The fund went from approximately $300 million in assets to $80 million in assets because they wouldn’t work with activists. I think it was arrogance on their part. . That’s a 75% drop in assets and revenue because they refused to negotiate.  We waited out the fund, showing fund managements that we will stick out hard fights. It shows that if a fund doesn’t want to negotiate, they can basically be put out of business.

Andy Dakos:  I’m just going to give one example of what did not work, and then I’ll give you an example of what I think is good.  We haven’t run a proxy contest that went to a meeting since summer of 2009.  We were in the midst of a proxy contest with a municipal bond fund.  We had built our position at a high teen discount previously. We gave notice to the fund and the board said the notice was not proper. Ultimately, we didn’t run the contest that year. It was not a staggered board; the whole board was up for vote. During that time, there certainly could have been an opportunity to sell and close out our position.

We determined at that time to continue to pursue a proxy contest, to get control of the board. Although we lost a lot of votes at that meeting, we did prevail. We ended up taking over the board. We conducted a large tender offer that took out all the shareholders that participated at 99.5% of NAV. The shareholders then approved a change in the mandate of the fund.  After the tender offer the fund shrank from $290 million in assets, down to about $92 or $94 million. I think that from the big picture standpoint, I think that was a seminal event for us. It really showed us what we may be able to accomplish. We haven’t had to run a proxy contest since then, I don’t think that is a coincidence.  We can generate some return for our investors, the fund can go on. Here is an example on how you can lose the entire fund. This has increased our credibility for what we can accomplish in future contests.

JCS: How do you see the retail shareholders of the funds, as long – term shareholders, benefiting from liquidation?  Also, a lot of people say that the activists benefit more than the retail investor, what is your reply to this?

Art Lipson: We are always looked at with suspicion because we are a hedge fund; we have that label. Opportunists or hedge funds, those are terms that describe the investment style, but it has nothing to do with ethics or fairness to all shareholders. We go into every fund contest and make a statement that we intend to offer the same results to every single shareholder as we get at Western.  We have done this in every case, so a shareholder can expect to get the same result, and we are not taking any special fees; we’ve never taken green mail or anything like that.  In terms of the outcome, sometimes, like with an open–ending, it’s obvious that everybody gets the same result, but other times it will be resolved through a tender and shareholders there have the choice of whether or not they want to participate in the tender or not and we don’t get any special larger allotment than they do.  For us it’s about fairness because we know we are going to be in future contests down the road and we want to have credibility with moms and pops.  We don’t want to give ammunition to those proxy solicitors who would use it against us if they could in a contest.

JCS: My feedback would be that, the average owner of a closed–end fund doesn’t watch them, or change their decisions actively so they may not even notice that a tender offer popped up and then say “oh I wish I had gotten part of that” too late. Part of the problem is that in my opinion, too many closed–end fund investors don’t monitor their holdings, or they feel like they are going to own a fund forever.

Andy Dakos: Well, I would say, if you own the stock, it seems to me like you should pay attention, but I can understand where you are coming from.  Just answering some of your questions, all shareholders large and small will benefit in that they are going to capture the discount.  They may want the [investment] exposure going forward, but I can’t think of a case for that asset class where there hasn’t been a vehicle for a shareholder to reinvest those proceeds, sometimes at a discount.

There are plenty open–end funds out there, certainly closed–end funds, that can be invested in at a discount, so I don’t think retail shareholders are harmed at all by liquidation, in fact I think it’s a benefit.

JCS: I have one final question before we open it up to the floor.  Why isn’t there more closed–end fund activism?  I mean, on a simple level, you find something trading cheap, you buy enough to cause a change, and you capture the difference of making it “less cheap”.  Is there a reason why you don’t see more competitors on the landscape doing the business that each of you conduct?

Art Lipson: That’s an interesting question.  I think the return profile is fairly modest.  When you think of activism, sometimes you think of getting an operating company to change its business plan and move up fifty percent, whereas, we are often looking at five or ten or fifteen percent total profit. Those that are well known as activists are looking for much higher return possibility; some of these players are billion dollar players and there just isn’t enough dollars in the closed–end fund situation to attract them.  I think it’s a lower return, but it’s a more assured return as a CEF activist.

Andy Dakos: Just like any activist, whether it’s within the closed–end funds space, or in large–cap operating companies, small–cap companies, it’s a rather simple business model. But it’s difficult to execute, it’s not without risk and there is always the potential for litigation that could drive up costs.  The closed–end fund sector is just a very small sector of the overall set of publicly traded securities.  So I think again, it’s what Art said, in terms of return profile plus the risks and costs associated with it.

JCS: With that I would like to get some questions from the audience, hopefully there’s some good ones.

Audience Question: How important is it for you to analyze the investment holding of a CEF when making an activist play?

Art Lipson: Well, we are trying to fully hedge all the time and there are some funds that engage in strategies that make it very difficult to hedge. We might find those less attractive as activist candidates.  Some of these funds have very high turnover like the Alpine funds that just cut their dividends.  They have a dividend capture policy, which I don’t believe works in the market, I think it produces negative returns.  What it means is they buy a stock, hold it up to, close to, the x–date and then when the whole world knows it’s going to pay its dividend, they try and sell it into demand and then buy some more stock farther away from its x–date.  They are not successful at this strategy, they have continuing NAV loses and for us to take an activist position in what we think is an under–preforming strategy, we could lose more in percentage profits than we gain by the boost at the end.  It’s hard to believe it but there are funds that do have some bad policies and occasionally you do get the fund with management whose securities selection is terrible and there a number of funds that manage to go out of business all by themselves without any help from Bulldog or us, especially ones that invest in say mortgage – backed securities or leveraged fixed income.

Andy Dakos: We certainly have a handle on what the funds do and what the exposures are.  But, that’s really more about diversifying our whole portfolio.  We do hedge from time to time but that’s really only when we have outsized exposure in any one area, for example in a particular emerging market.  We see a cheap asset, if we are able to generate  alpha  from discount narrowing and if you do that year – in and year –out, the returns, certainly in the intermediate to long–term should be good, certainly against the benchmark.

Audience Question: Under the Investment Company Act, section 12B, it limits your ability to accumulate shares in these closed–end funds with a 3% cap.  Does 12B limit your ability to engage in activism by limiting your ability to accumulate?

Andy Dakos:  No. It’s really for the reason that you point out, managing a number of different entities, so it has not impacted us.

Art Lipson: Same here, it has not been a problem.  Of course, we have had excellent counsel in terms of setting up the structure of our business.  In doing that, with a number of separate entities, 12B is not that restrictive at all.

JCS: Any further questions?  No. Alright this one is for Bulldog because of Special Opportunities Fund (SPE). How do you balance the fiduciary duty to your clients as an investment firm and then to the shareholders of the closed–end fund that you are involved with in a board capacity?

Andy Dakos:   Whenever a principal of Bulldog is on the board, we basically are not involved in any of the decisions with regard to that position that is held by the entity that we advise.  The decisions are made by another portfolio manager and there is a Chinese wall set–up.

It’s a big decision for us, more so today than ever I think, in terms of whether or not it makes sense for us, as opposed to other nominees that we might recommend to sit on a board, whether it’s a closed-end fund or an operating company, as it’s certainly a big time commitment.  It’s important to keep your question in mind John.

Art Lipson: The closed–end fund market in my mind continues to be irrational. We can look at that  SPE fund that Bulldog took over and I’m for example a shareholder in my IRA and my regular funds.  You have a situation where you have a management company that has a clearly above average record, I happen to know the principals directly and know how intelligent they are, but the record reflects that, and yet it’s available at a discount.  This is also a question of why a discount would exist in a fund entity that has a 15 year proven track record of performance; it seems silly to me.  I recommend that (SPE) stock to pretty much anybody and their grandmothers and grandchildren.

JCS:  We just have 30 seconds left.  I’ll just recap that from the closed-end fund space in the last 10 years we have averaged about 8 to 9 deaths in the sector per year, we average about 11 mergers during per year, we have averaged 28 IPOs per year.  Last year that there were 57 mergers, primarily a lot of small muninicipal bond funds at the state level going from 3 or 2 funds per sponsor to one.

With that, I know I’m sticking around, the panelists will be around, and come up to any of us to ask some more questions.  Thank you both for your insight to the world of CEF activism and DealFlow Media for putting on this conference. It was my pleasure to serve as your moderator. More information about the conference can be found via: http://www.dealflowmedia.com/conferences/activist_conference_2013/

Closed-End Fund Advisors started tracking two new data points we thought would help us select and compare dividend risk for a closed-end fund. They are Undistributed Net Investment Income Trend (UNII) and Earnings Trend. By taking the slope of the last three UNII and earnings figures for a fund, a trend is determined as “up”, “flat” or “down”.

When CEF collects dividend and bond income and pays a regular dividend to shareholders, it reports UNII as a line item on its balance sheet. If a CEF increases its UNII balance, it has more reserves on hand to possibly distribute as a dividend. Increases in earnings also gives the potential that a fund could be increasing its dividend level in the near future. When these figures are in line with each other (i.e. both earnings and UNII trends are positive or both negative), it makes a stronger case that either the fund is increasing or reducing its future income production. This, in our experience, makes it more likely that the Board may alter their dividend policy accordingly.

At CEFA we also believe Earnings Coverage Ratio (ECR) may be a predictor of dividend changes. This data point is defined as the current average earnings per share (EPS) divided by the appropriate dividend per share. Earnings above the dividend policy can result in increased UNII. Increased UNII can increase the fund’s ability to navigate poor markets or poor investment decisions by the portfolio manager.

Since we believe these three data points (UNII trend, earnings trend and earnings coverage ratio) all are relevant to dividend changes, we sought to find a combination of the three that gave us the highest confidence levels to predict a dividend change for a municipal tax-free bond CEF. We picked this CEF group as there are over 100 funds in which to identify a trend. This allowed us to review and identify a correlation between our data and the board of director’s distribution changes.

Our research began by examining each major category of CEF’s (equity, taxable bond and tax-free municipal-bond), attempting to find the category that most correlated with these metrics. What we found was a high correspondence between dividend cuts and downward UNII trend. This makes sense as reduced UNII means the fund has less of a cushion to distribute to its shareholders, possibly warranting a cut. The next step was finding a combination of these metrics that gave us the highest confidence levels for predicting a distribution cuts. Below is a graph showing the Relative UNII for all National Muni Bond Funds in 2012.

In addition to UNII trend, we saw a relationship between dividend changes and earnings coverage ratio. As a reminder, the earnings coverage ratio is defined as current EPS over dividend per share. A ratio greater than 100% means the fund can cover its distribution with its reported earnings level. Any figures below 100% mean the fund may  not be able to distribute solely from its earnings, but possibility from capital gains, return of  capital, or from its UNII balance.

As seen in table above, there is a trend between the funds that cut, maintained or increased dividends and their respective ECR’s. It should be noted that during this time span, there was an overwhelming amount of dividend cuts compared to increases, the majority occurring in December. Because the sample size for increases was so small, we again narrowed our focus to dividend cuts. Increases also all occurred in the 4 Build America Bond funds. We only looked at funds that report UNII monthly which equals around 62% of the total number of funds in the category. We felt this was the best way to look at funds on an equal basis though various market fluctuations.

Given the significant relationships between dividend changes with both ECR and UNII, a combination of the two must yield a significant figure in predicting dividend cuts. In funds that cut their dividend in the last four months AND have an ECR of less than 100%, 91% of the funds had a downward UNII trend.

Given these results, we now know looking for a Muni CEF with ECRs of less than 100% and a downward UNII trend can be a useful first step in predicting a dividend cut, and should generally be avoided by income oriented investors.

One concern we noted with these findings is the fact that some funds with negative UNII trends and ECRs under 100% did not cut their dividend. This is puzzling, as a fund that is unable to cover its dividend with its earnings AND is using up its UNII does not feel the need to reduce its distribution. A possibility to consider would be short and long term gains for the funds that would help cover the dividend. One way to quickly check for this is to look at the composition of distributions for each fund, for short-term/long-term capital gains or return of capital for the fund.

In every fund that met our criteria, none had any distributions reported as anything besides income. We will continue to closely monitor a CEF’s data and dividend announcements for CEFs in 2013, hoping that we can improve our dividend increase/decrease predictability.

Note: This project and article was conducted and written by Andrew Pavloff, a senior at The College of William and Mary who has been externing with Closed-End Fund Advisors for the 2012-2013 academic year under the direct supervision of John Cole Scott.

This web based session will cover the current state of the Major CEF Groups: 1. US Equity, 2. Non-US Equity 3. Specialty Equity 4. Taxable Bond Funds 5. National Muni Bond Funds and highlights on many of the numerous sub-sectors in those groups.

We will cover:

• Discount Trends
• Over and Undervalued Groups of Funds
• Compare Net Asset Value Performance
• Changes in Dividends: UNII Coverage and Return of Capital
• Changes in Activist Positions and Fund We Anticipate Activist Activity
• Our Outlook for the Current Quarter
• Recent IPO Review and our CEF IPO Guidelines.

Register via: https://www2.gotomeeting.com/register/394738858

We will load the slides and replay about 48 hours after holding the session on our Webinar Archive Page. http://www.cefadvisors.com/webinars-on-demand.html

From our experience, if you are interested in closed-end funds then you typically fall into two groups of investors: Dividend Seekers or Contrarian Investors.

Regarding contrarian investing, can investors currently find value amongst the roughly 219 available equity closed end funds? For those not familiar with some of the data we collect and use, please review CEFA’s CEF Data Definitions. Data used in this article is from our weekly CEF data service, “CEFA’s Closed-End Fund Universe” dated December 28, 2012.

Research Criteria: 1) Less than 15% of assets invested in US stocks. 2) Current discount to NAV of more than -10%. 3) Relative discount wider than -1.5% (90 day average discount) 4) Comparable discount (vs. peer group average) wider than -2%. 5) 1-year Z-stat of less than -1.0. 6) Relative Z-stat of less than -0.5. 7) 1-Year discount range under 15%.  8) 52-Week relative market price under 33%. 9) 1 Year NAV total return performance above + 10% through December 28th 2012. 10) Trading more than 30,000 shares per day.

Non US Equity Fund
BlackRock International Growth & Income Fund (BGY)

Concerns: 81% of the dividend over the past 90 days is classified as return of capital, however they just cut the dividend by -24% in September of 2012. We anticipate the next quarterly dividend announcement date is Friday, March 1.

US Equity Fund
BlackRock Enhanced Equity Dividend Trust (BDJ)

Concerns: Return of Capital is listed as 73% over the past 90 days, but the trend of RoC is down which we favor. The dividend level was cut -18% in December which often is a better time to buy into a fund.

Conclusion: While we did not search for above normal dividend paying funds when we conducted our research, we ended up identifying funds with significant dividend levels. It should be noted that the average equity CEF currently has a total yield of 7.2% which makes this possibility unsurprising.

Both funds have reported return of capital (RoC) in their recent distribution section 19 notices or press releases. Inside the CEF industry there is both deep concern and investor preference for RoC in a fund’s dividend. Why? The RoC benefit is  that portion of the dividend is not taxed as income or capital gains, but your cost basis is reduced by the RoC amount, effectively making it a tax deferred investment.The risk for RoC is that if the fund cannot earn, produce or grow its dividend policy through its investment work in the portfolio then it will erode NAV over time. This can reduce the ability to produce future dividends as well as reducing liquidity and raising the expense ratio over time.

CEFA advocates active monitoring a funds financial reports as well as data to help anticipate risks beforehand and believes that the current discounts offered in both these funds take RoC   risk into account. We also prefer to buy a fund within a few months of a dividend cut as investors often sell the price down to increase the yield and widening the discount.

CEFA’s Data Definitions: http://www.cefadvisors.com/Download/CEFUDataDefinitions.pdf

Disclosures: CEFA does not hold positions in BDJ or BGY and will not buy any shares for 72 hours. The information and statistical data contained herein have been obtained from sources that Closed-End Fund Advisors (CEFA) believes are reliable, but CEFA makes no representation or warranty as to the accuracy or completeness of any such information or data and expressly disclaims any and all liability relating to or resulting from your use of these materials. The information and data contained herein are current only as of the date(s) indicated, and CEFA has no intention, obligation, or duty to update these materials after such date(s). These materials do not constitute an offer to sell or the solicitation of an offer to buy any securities. CEFA may make decisions for its clients in certain of these securities. CEFA and/or their respective officers, employees, and affiliates may at any time hold positions in any of these securities and may from time-to-time purchase or sell such securities.

“A Crash Course in Closed-End Funds: Benefits and Risks for a Rising Rate Environment”

The Video: Running Time: 59 minutes

http://vimeo.com/55607500

The Slides (PDF format):

http://www.cefadvisors.com/Download/CFA-VA-2012-1213.pdf
Thank you to CFA Virginia for sharing the video for our use.