Lipper Research Senior Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN Tuesday - Closed End Funds
Tuesday, October 18, 2005
Q. Don, you told us off air you'd like to talk about closed-end fundstoday.A. Right. There are some developments I think people should be aware of.
Q. First, though, maybe you'd better define what they are.
A. Of course. A closed-end fund is a registered investment company thatdoes not stand ready to redeem its shares from holders every day that theNew York Stock Exchange is open. Most (but not all) closed-ends trade onstock exchanges and that is not an essential part of the definition of one.
Q. About how many of them are there?
A. Presently between 640 and 650 in the United States. Lots listed also inLondon and Hong Kong.
Q. Are they a big part of the funds industry picture?
A. Hardly! Total assets are about $230 billion, which is a little under 3%of total industry assets.
Q. Where do people find out about them?
A. There are big tables (supplied by Lipper) showing premiums and discountsin Section C of the Wall Street Journal on Mondays, and a breakout tableshowing just change in market price the other four days of the week. Thereis a nifty free website called www.ETFconnect.com, and you can find dailydata there. For news developments, I'd go (free) to www.CEFA.com.
Q. So, what is happening that is concerning you?
A. Well, about 70% of closed-end funds use leverage. That means they borrowmoney in one way or another, to help create a higher dividend stream.People love current income, and that has made Closed End Funds (CEFs) easyfor Wall Street to place with clients over the years.
Q. So, what is wrong with leverage now?
A. Well, two things can and probably will go wrong. First, we all know theyield curve has been flattening. That means that the borrowings that CEFsdo to get their leverage cost them more money, and that means their abilityto pay past levels of dividends is getting reduced.
Q. And no one likes a dividend cut!
A. Right. And when they happen, people sell the income-CEFs shares indroves and the price takes a hit, often in the 15-20% range pretty quickly.
Q. Anything else?
A. Yes. It looks like the market is starting to take the threat ofinflation and higher long interest rates more seriously. Just in the pastweek the average discount on CEFs widened by about 1.5%, which is a verybig move.
Q. And you are owning the assets in a leveraged account?
A. Exactly. If your fund owns municipal bonds, Real Estate InvestmentTrusts, utilities, preferred stocks, or anything else that is sensitive torising interest rates, the Net Asset Value and market value of your fundwill fall as rates rise, and leveraged funds will fall faster than others.
Q. So, are you recommending that people sell out of these?
A. We at Lipper do not actually make buy/sell/hold recommendations. But Ithink we are at a point when people need to re-assess where they are, andwhat their tolerance is for possible downside risk. If you believe thatinflation will rise and that long-term rates will go up, you should expectsome erosion of prices in income-type funds, and leveraged funds will seemore erosion than those that are not leveraged. Each investor needs todetermine his or her own tolerance for downside, and act accordingly.
Q. What about people who say they are "long-term investors"?
A. A lot of people say they are that, but when pain gets sharp they tendto sell out. And that happens near bottoms, not tops. So I would suggestpeople look clearly at their own past behavior to see if they really willhold through any downturn in prices.
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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).
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