Remarks Before the ICI 2011 Closed-End Fund Conference
Director, Division of Investment Management
New York Marriott Downtown
November 17, 2011
New York, NY
Good afternoon, and thank you for inviting me to speak here today. Let me make the usual disclosure that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the SEC staff.1
We have just listened to the panel on “How Closed-End Funds Fit in Today’s Markets.” I am reminded that the last time that an SEC Division of Investment Management Director spoke about closed-end funds at this conference was in October 2007. A panel on the same topic back then probably would have sounded somewhat different. 2007 was in many ways a peak year for closed-end funds -- their assets were about four times what they are today; they issued more than three times worth of new shares in 2007 than they did last year; and 2007 saw the biggest-ever closed-end fund IPO of $5 billion dollars.2
Year 2008 was not kind to the closed-end fund industry. During the financial crisis, the average closed-end fund discount to NAV hit record levels -- it was estimated to be more than 15%, with 443 closed-end funds trading at double-digit discounts.3 Yet perhaps the financial crisis will be remembered by the closed-end fund industry primarily as the event that, for the first time in history, froze the market for auction-rate preferred shares, or ARPs, one of the funds’ key sources of leverage.
Three years after the financial crisis, it is not uncommon to read that closed-end funds still are “suffering a bad rap,” that they “lack fans,” that investors are “shying away” from their IPOs, or that their investors are still “spooked.”4 And then there are the various reminders that the ever-growing ETFs and ETNs are muscling in on some of the closed-end funds’ traditional investment territory.
It is probably fair to say that in 2011, closed-end funds are still looking to regain their footing in the post-financial crisis investment environment. Some significant strides have been made -- I was glad to find out that, as of the end of September of this year, over 77% percent of ARPs that were outstanding when the markets froze in 2008, have been redeemed as funds found other comparable sources of financing or decided to de-leverage.5
Overall, these are challenging times for investors. Stresses on the global economic order have led to sharp market volatility increases, accompanied by redemptions from equity mutual funds. During periods of stress -- more than ever -- I believe that it is important that funds do all they can to maintain high standards. Only by doing so will they continue to earn and retain the confidence of investors.
One area in which standards should be held high is that of informing and educating investors. For example, leverage is often a difficult issue for investors to understand and put in the right perspective. And not only for investors. For closed-end funds themselves, some leverage, such as bank debt or issuing preferred stock, may be straightforward to quantify and explain. Other leverage, such as tender option bonds or reverse repos, may be more complex and variable. In the last few years, as many closed-end funds may have shifted from using ARPs to other forms of leverage, including derivatives, they may be facing new challenges in giving their investors an understandable picture of their leverage profiles.
If leverage materially affected a fund’s performance during its fiscal year, I believe the fund should discuss this factor in its annual report. About a year ago, my Division staff sent a letter to the ICI providing its most recent observations about derivatives-related disclosures by investment companies in registration statements and shareholder reports.6 The letter noted, for example, that some funds that appear to have significant derivatives exposure in their financial statements, have limited or no discussion in their annual reports of the effect of those derivatives on the funds’ performance.
Even apart from the regulatory requirements, leaving investors in the dark about the role that leverage plays in the management and performance of their portfolios cannot be good for the closed-end fund business. An investor reading a fund’s annual report should not have to dig through the footnotes in the financial statements to understand the material impact that derivatives -- or leverage generally -- may have had on the fund’s performance. Unfortunately, some closed-end fund investors are still in that position today.
At the other end of the spectrum, many closed-end funds do an excellent job of communicating to their investors on this topic. These funds’ annual reports speak pointedly and clearly about the role of leverage in their performance. They manage to convey to investors what is important about their funds’ often complex leverage strategies in a simplified but focused and accurate manner. I believe that these investors are well served.
The complexities of how best to inform and educate investors about leverage in general, and derivatives in particular, are well known to us at the Commission. My Division is beginning to analyze the comments that have come in on the Concept Release on derivatives, which the Commission issued at the end of August.7 The Concept Release did not speak in detail about disclosure issues, but it did devote significant attention to the treatment of derivatives under the leverage, portfolio diversification and concentration requirements. These are all issues that go to providing investors a complete and accurate picture of their fund. The Concept Release also broadly invited comments on any derivatives-related issues that commenters felt were relevant to the use of derivatives by funds. We welcome and appreciate your views about derivatives-related issues from the closed-end fund community’s point of view.
As the markets work through this challenging period, I hope that the closed-end fund industry as a whole makes the commitment and re-doubles efforts to provide investors with appropriate disclosure about leverage and derivatives. Take a fresh look at your funds’ shareholder reports and websites, because these are the places where your investors, as a practical matter, look for information about their funds. Efforts spent on these channels of communication will not only benefit your investors, but will be good for business, too.
Speaking of what is perceived as “good for business,” a Morningstar article recently observed that “many closed-end funds live and die by their distributions.”8 In today’s environment of historically low interest rates, many closed-end funds are finding managed distribution policies to be magnets for yield-seeking investors. Couple that with the low cost of leverage, and many closed-end funds may be tempted to further increase the size of their funds’ distributions. Last year, for example, there were 566 announced distribution increases, compared to 187 distribution reductions, and the average change in distribution was an increase of 6.6%.9
Of course, managed distribution policies have been around for as long as closed-end funds themselves, with mixed results and some historical lessons. The 2007 speech to this audience by my predecessor in the Division, cautioned about several issues: the importance of timely disclosure to investors regarding the sources of fund distributions; making clear to investors the extent of a fund’s ability to sustain its current distributions; the need for monitoring of distribution rates by fund managers and directors; and the appropriateness of continuing with a distribution policy.10
It was a timely caution. The market events of 2008 -- combined with the effects of the tax rules -- led a number of closed-end funds to reduce their distribution rates or discontinue their managed distribution policies altogether. These developments made real the need for good disclosure and investor understanding of managed distributions.
As we once again face a market under stress in 2011, and as investors seek refuge in yield, it is critically important to conduct business in a way that does not undermine the protection of investors. A growing segment of our population is approaching retirement and seeking yield-generating investments. It would be great if we could agree to raise the bar for informing and educating investors.
And of course we all know that a few “bad apples” can tarnish an entire industry. When certain closed-end funds appear to have distribution rates that are significantly higher than their portfolios’ average annual total returns,11 it suggests an unsustainable posture that may end badly for shareholders. We should all worry when Morningstar observes that closed-end funds with high distribution rates -- particularly those that provide the least information about the sustainability of their distributions -- tend to trade at the highest premiums and are “market successes.”12
I think we would all agree that there is no “market success” when it concerns poorly informed investors on the issue of closed-end fund distributions. One cannot help but remember that closed-end funds have known their share of market “bubbles.” In fact, closed-end funds as we know them today arose out of the ashes of the infamous 1929 closed-end funds bubble. It was a time of spectacular growth for leveraged closed-end funds and premiums that reached the sky. In 1929, the premiums averaged 50%, and the hottest new closed-end fund issues sometimes traded at 200% of NAV.13 It was also a time marked by a lack of transparency that bordered on secrecy.
After the great crash of 1929, one of the key ways in which closed-end funds sought to resurrect the industry was through a coordinated effort toward greater transparency to inform and educate the investing public about themselves. And the focus of that effort was not on pages and pages of “boilerplate,” but on actually getting across to an investor what sort of thing he or she would be getting when buying a closed-end fund.
That real effort at transparency -- and the substantive regulation in the form of the Investment Company Act -- is what enables us to be here today to discuss the state of the closed-end fund industry in the year 2011. And yet, we are still talking about transparency and distribution policies. Reputation is far more easily lost than regained, so I encourage all to disclose clearly and completely, and to set distribution policies that will manage, and meet, investor expectations appropriately over the long-term. I’m happy to have had the chance to speak with you today. Thank you for your time.
1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
2 See Ian Salisbury, “Closed-End Funds Lack Fans Post-Crisis,” Smartmoney.com (May 17, 2011).
3 See Cara Esser, “How CEFs Fared During the Market Tumult,” Morningstar.com (August 8, 2011).
4 See Murray Coleman, “Closed-End Funds Seen as Suffering Bad Rap and More Competition,” Barron’s (May 16, 2011); Ian Salisbury, “Closed-End Funds Lack Fans Post-Crisis,” Smartmoney.com (May 17, 2011).
5 See Thomas J. Hertzfeld Advisors Incorporated, “The Investor’s Guide to Closed-End Funds” (September 2011).
6 “Derivatives-Related Disclosures by Investment Companies,” Letter from Barry D. Miller, Associate Director, Division of Investment Management, SEC to Karrie McMillan, General Counsel, Investment Company Institute (July 30, 2010).
7 Use of Derivatives by Investment Companies under the Investment Company Act, Investment Company Act Release No. 29776 (August 31, 2011).
8 Cara Esser, “Managed Distribution Policies: Here’s the Catch,” Morningstar.com (September 24, 2010).
9 Mike Taggart, “2010 Has Been the Old Normal for CEFs,” Morningstar.com (December 31, 2010).
10 Andrew J. Donohue, “Luncheon Address at the 2007 ICI Closed End Fund Workshop,” (October 11, 2007).
11 See Thomas J. Hertzfeld Advisors Incorporated, “The Investor’s Guide to Closed-End Funds” (August 2011).
12 Mike Taggart, “Does Transparency Matter to CEF Investing?”, Morningstar.com (April 8, 2011).
13 See U.S. Securities and Exchange Commission, Investment Trusts and Investment Companies (1939-1942), Part 2, at 805-818.