On Friday, November 19th, 2010, the market price of Energy Income and Growth Fund (FEN) declined by 92 cents to $27, while the Net Asset Value (“NAV”) increased by 14 cents. A market premium narrowing from 8.01% to 3.89% in one day showcases the supply demand dynamics affecting Closed-End Funds. It is easy to appreciate why people are afraid of Closed-End Funds (“CEFs”).
Perhaps people should be afraid of them. CEFs require a tremendous attention to qualitative detail and average investors often mistake their surface level information value added insight.
The more important observations from Friday’s action in FEN was the catalyst for market move, and the hesitance which began being displayed among true expert CEF market participants for buying the dip. Between Thursday Night's News, and FEN's structural orientation, FEN appears a particularly troubling choice for accessing the MLP asset class. FEN now, or soon will emit attractive pheromones to those who focus exclusively on quantitative analysis. Its narrow premium is attractive in relation to its far higher average historical premium valuation. The attraction is likely to prove more costly than a high end call girl, in my view. Unless they are simply closing unhedged short positions, I doubt true experts are likely to be buyers of FEN anytime soon.
FEN Governance History
The catalysts for Friday’s move was a secondary offering, priced at $27.25 and after an $1.09 underwriting discount added $26.16 in proceeds per share, before expenses, to the fund. Before is not an irrelevant word. Such aggregate expenses, (which is different from the underwriting discount)were approximated to be $170,500, all of which will be borne by the Fund.
Such a governance choice for a Closed-End Fund increases Assets Under Management (“AUM”) and clearly benefits those who earn assets under management fees. In this case, AUM increased by more than $41 million. The immediate effect on existing shareholders was pretty clear.
The possibility that such governance actions may reflect a Governance interest in maximizing AUM in spite of the detrimental effects may cause Mr. Market’s longer term pricing dynamics to reflect broader assessments of the funds governance.
FEN Structural Inefficiency
As unappealing as Friday’s news was, what I feel is a bigger long term issue is not unique to FEN. While better known as a Closed-End Fund, FEN is technically taxable as a C-Corporation. Like other Closed-End Funds (ie: FMO, KYE, KYN, NTG, TYG, TYY), Mutual Funds (MLPAX, MLPOX, MLPDX, MLPZX, MLPFX, MLPTX, CSHAX, CSHCX, CSHZX), and the ETF (AMLP) that invest in MLPs, its NAV should account for its tax burden. I documented one demonstration of the financial effect in Nuveen’s MLP & Strategic Equity Fund Inc (MTP), upon it writing down its NAV by $1.05 per share overnight. Chuck Epstein, an award-winning financial writer who has written by-lined articles for over 50 financial publications and clearly a proponent of progressive change in the asset management industry also just covered the C-Corporation product phenomenon among other important MLP investing topics.
In short, the C-Corporation structure generally constrains NAV performance to less than 70% of the long term performance of underlying securities. So, assuming positive long term returns if the asset class proves to have investment merit over time, FEN’s NAV performance is highly likely to underperform even a random sample of the MLP asset class constituent. I am not advocating the throwing of darts as there are numerous single security hazards in a sector cluttered with conflict of interest. Significant Incentive Distribution Rights (“IDRs”) to an MLP holdings’ General Partner may be a very concerning indicator of potentially conflicted interest.
Rather, the C-Corporation structure of an MLP focused single security investment wrapper is far less efficient than direct ownership. Therefore, in addition to inferior NAV returns, FEN may prove to be subject to insufficient market demand for its product shares and thus be assigned a wide discount by Mr. Market over time. I’m surely not advocating to own MLP ETNs (AMJ, MLPN, MLPI), which themselves have distribution challenges and in their manufacture create new credit risk.
I love Closed-End Funds generally, but Closed-End Funds investing in MLPs may prove upon widening discounts in addition to incomplete asset class participation even worse than AMLP. To be clear, that is not a compliment to AMLP.
No Critique of FEN Portfolio Managers
While I may not identify with whether a C-Corporation Structure for an MLP investment vehicle should ever exist, I am in no way blaming passing judgment on the management of FEN. While there are some holdings in the portfolio, even among the largest holdings, which I personally find to be subject to Conflict of Interest risk that discomforts me, I do not challenge that they do their due diligence. The pool of investable MLPs is not huge and perhaps they are open to some things I am not open to in desire of having more diversification than my own 16 Direct MLP holdings.
The people behind FEN very well may be great people. They have a great challenge in outperforming the asset class to such an extent to make up for the C-Corporation tax classification. The same is also true of AMLP, the index ETF, and other MLP focused Mutual or Closed End Funds, of course. The same is even true of FMO, which itself did a secondary and has been a subject of my writing.
Disclosure: No positions in securities mentioned.