The Scott Letter: Closed-End Fund Report©
Published by Closed-End Fund Advisors, Inc.

May/June 2003, Volume III, Issue 5
George Cole Scott, Editor

"Wall Street went on deflation watch last week. The deflation signal was sounded when both producer prices and consumer prices fell, but neither economic indicator provided definitive evidence of deflation. Inflation is dead, consumer confidence is better than it’s been in a year, interest rates are the lowest they have been in a lifetime yet Wall Street is clearly more nervous about the health of the economy and strength of stocks.”

— Wiesenberger Closed-End Weekly Review Friday, May 16, 2003

The Accelerating Interest in Closed-End Fund

During 2002, closed-end fund (CEF) IPOs raised $17 billion, almost three times the pace observed in 2001. Sponsors of such funds were able to attract additional assets through preferred offerings, thus gaining nearly $25 billion more of fee-based assets. The current yield curve, which is likely to persist for 2003, should continue to facilitate new assets raised for leveraged closed-end funds next year. [Many new funds were able to enhance yields through leveraging. — Editor]

Of course, new investor education is further complicated today since there are additional risks embedded in the use of leverage. Furthermore, when interest rates go up, not only will NAVs decline as de-leveraging reduces payouts,  but also the likely selling action at that time by some investors would push down the traded price and create a significant discount, at least temporarily.

Certain closed-end fund sectors are likely to slow down, especially when there is a glut of new offerings, undistinguished from older ones, which are selling at attractive yields. Of course, when existing funds are traded at a discount and thus offers higher yields than a new fund similarly invested and priced, a financial advisor needs to carefully evaluate new IPOs and their advantages to the investor.

Quoted from Strategic Insight Overview,

In the following weeks, the U.S. markets continued their rally, boosted by positive economic numbers. Prices for insurance, health care, college tuition, home heating and baseball tickets have all been rising smartly. Yet Federal reserve governors and other sages are warning about deflation. As Jerry Seinfeld might ask: “What’s up with that?”

Sure, some prices are going down — for computers, airfare and clothing. But deflation refers to prices that are falling across the board, and we don’t see much evidence of that. Except for a quarterly decline of the Consumer Price Index in 2001, neither the CPI nor the index of Personal Consumption Expenditures (the Fed’s favorite measure) is registering a general price decline. For the 12 months ending in April, the CPI was up 2.2% and the PCE, excluding energy and food prices, was rising at about a 1% annual rate. Looking ahead, the case for deflation seems even less convincing. The dollar, which has fallen decisively against the euro over the past year, may well fall some more. A weaker dollar generates inflationary pressure by raising the dollar-price of imports while at the same time making imports less competitive and allowing domestic companies to raise prices. — The Wall Street Journal, May 29, 2003

Emerging Markets Mobius Speaks to Analysts

NEW YORK  (Dow Jones). The discounts at which shares of emerging- market closed-end funds trade may provide a valuable clue regarding the direction that those markets are headed, according to noted fund manager Mark Mobius.

"The discount of emerging markets’ closed-end funds is a wonderful indicator, a leading indicator of sentiment in emerging markets generally," Mobius said.

"Unlike open-end mutual funds, which regularly issue new shares and buy them back upon demand, closed-end funds issue a fixed number of shares that trade on an exchange. The shares will often trade at a price lower, or at a discount to their net asset value. If you keep track of the discount/premiums of emerging market funds, you can get a pretty good idea of what’s going to happen in emerging markets, whether the market’s generally going to be going down or up,” Mobius said, indicating that a narrowing of discounts is a positive indicator for the sector.

The portfolio manager’s comments were at a closed-end fund conference in New York in April. Dr. Mobius is known for his prowess as an emerging-markets investor, and he currently oversees several closed-end fund portfolios including Templeton Emerging Markets Fund (EMF), Templeton Russia Fund (TRF) and Templeton Dragon Fund (TDF).

He also addressed some of the challenges for closed-end equity fund managers – one of which is pressure from shareholders to eliminate discounts. More and more, hedge funds and other arbitrageurs “who want to do something actively about eliminating discounts” have been putting pressure on fund managers to buy-back fund shares, Mobius said.

Share buybacks don’t have a long-term influence on share-price discounts, and they lead to higher average costs per share borne by shareholders. Buy-backs are also hobbled by trading restrictions, Mobius explained, such as no buying of stock on the opening and closing bell and no more than 25% of the daily trading volume, the manager said.

Emerging markets that Mobius currently favors include South Africa, Korea and China. Those that he isn’t favorable toward or invested in include Venezuela, Columbia, Peru and Ecuador (April 2003). Mobius added, “that doesn’t mean that we wouldn’t be in there again.”

Real Estate Investment Trust Review
Cohen & Steers Realty Shares
Letter to Shareholders dated April 9, 2003

Investment Outlook

The investment performance of REITs over the past 18 months has marked a sharp change in attitudes of a broad range of investors. While we have never been proponents of analyzing funds’ flows in order to gauge or predict investment performance, there is now convincing evidence that new sources of demand for REIT shares are having a strong influence on valuations. Emerging data suggest that significant capital is now flowing to the REIT industry, much of which we believe is permanent. This contrasts to the late 1990s, when investor capital flowed into and out of the sector primarily as a result of changing price and profit momentum.

Since Equity Office Properties became the first REIT to be added to S&P 500 Index in October 2001, 17 other REITS have been added to this and two other major S&P indexes, creating demand for at least $3.6 billion worth of shares from index funds. Once these shares are purchased, they remain in these funds, subject to fund inflows and outflows, unless the company is deleted from the index. Based on market capitalization of REITS relative to the broader market, it is our belief there will be a continual increase in the number of REITS being added to these indexes. An additional source of permanent demand for REIT shares is the growing number of REITS being added to these indexes. An additional source of permanent demand for REIT shares is the growing number of closed-end mutual funds that invest exclusively in REITs. These funds have a fixed capital structure — their shares trade on major stock exchanges, and they do not allow for redemption or liquidation. Therefore, these funds must remain fully invested in REITs. Over $4 billion has been raised within this structure, and we expect more new funds to be created in the near future.

One further source of demand for REIT shares is an array of retirement accounts. Whereas during the 1990s less than 1% of retirement accounts (such as 401k plans) offered real estate options, it is now estimated that nearly 10% of such plans include REIT mutual funds in their menus. It is our understanding that this number is increasing steadily, with many prominent financial institutions recently adopting the REIT option. In addition, a growing number of financial planners and advisors have accepted REITs as an asset class that deserves representation in investor portfolios. Over the past 18 months, over $3 billion of cash has flowed into open-REIT mutual funds. REITs have also become a popular component of the real estate allocations of other retirement accounts such as defined benefit plans. Based on the reading from various institutional investment services, it is estimated that a further $4 billion has been committed to REITS over this same time frame.

Finally, with share prices of some REITs trading well below net asset value (this is what closed-end fund investors also look for) more and more companies are opting to repurchase their shares rather than make new investments. Indeed, because property prices have held up extremely well, many REITS have become net sellers of property, using cash proceeds to retire debt, fund share repurchase and, in some cases, just sit on cash in anticipation of future acquisition opportunities. We estimate that there have been over $1.5 billion of share repurchases over the past year and a half. Offsetting this is the issuance of approximately $6.5 billion of common equity by other REITs during the same period.

Recent Demand for REIT Shares

Index additions$3.6 billion
Closed-end funds$4.2 billion
Open-end funds$3.4 billion
Defined benefit plans$4.0 billion
Share repurchases$1.5 billion
Equity issuance$6.5 billion
Net demand$0.2 billion

Irrespective of when economic growth finally accelerates, we believe the REIT industry overall remains extremely healthy, as it is strongly capitalized and generates cash flow comfortably in excess of current dividends. Despite a small handful of dividend cuts, 29 companies have already raised their dividend payouts this year. As dividends tend to drive REITs’ long-term returns, these attractive dividend yields have the potential to make REITs even more popular with investors, especially in an environment where many analysts are lowering expectations for most other asset classes. Consequently, we expect REITS to remain an important and growing component of investors’ portfolios.

Martin Cohen, President Robert H. Steers, Chairman

Editor's Note: Because your editor has been out of the office on business, we were not able to get the May newsletter out until now. The next edition will be sent to subscribers in early July and will be an interview with a fund manager.

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