April 2011 IssueLong scroll reading

First Trust/Aberdeen Emerging Opportunity Fund (FEO)

By Editor

Objective

To provide a high level of total return by investing in a diversified portfolio of emerging market equity and fixed-income securities. The fund does not short anything but they may use derivatives to hedge their risks.

Adviser

First Trust Advisors, L.P., in suburban Chicago. First Trust is responsible for 29 mutual funds and a dozen closed-end funds. They tend to be responsible for picking sub-advisers, rather than for running the funds on their own.

Manager

A large team from Aberdeen Asset Management, Inc., which is a subsidiary of Aberdeen Asset Management PLC. The parent firm manages $250 billion in assets, as of mid-210. Their clients include a range of pension funds, financial institutions, investment trusts, unit trusts, offshore funds, charities and rich folks, in addition to two dozen U.S. funds bearing their name. The management team is led by Devan Kaloo, Head of Emerging Markets Equity, and Brett Diment, Head of Emerging Market Debt for the Aberdeen Group.

Management’s Stake in the Fund

I can’t determine this. The reporting requirements for closed-end funds seem far more lax than for “regular” mutual funds, so the most recent Statement of Additional Information on file with the SEC appears to be four years old.

Opening date

August 28, 2006

Minimum investment

Like stocks and ETFs, there is no minimum purchase established by the fund though you will need to pay a brokerage fee.

Expense ratio

1.80% on assets of $128 million. This calculation is a bit deceiving, since it ignores the possibility of buying shares of the fund at a substantial discount to the stated net asset value.

Comments

In my September 2010 cover essay, I offered a quick performance snapshot for “the best fund that doesn’t exist.” $10,000 invested in a broad measure of the U.S. stock market in 2000 would have been worth $9,700 by the decade’s end. The same investment in The Best Fund That Doesn’t Exist (TBFTDE) would be worth $30,500, a return that beats the socks off a wide variety of superstar funds with flexible mandates.

TBFTDE is an emerging markets hybrid fund; that is, one that invests in both e.m. stocks and bonds. No mutual fund or exchange-traded fund pursues the strategy which is odd, since many funds pursue e.m. stock or e.m. bond strategies separately. There are, for example, eight e.m. bond funds and 32 e.m. stock funds each with over a billion in assets. Both asset classes have offered healthy (10-11% annually over the past decade) returns and are projected to have strong returns going forward (see GMO’s monthly “asset class return forecasts” for details), yet are weakly correlated with each other. That makes for a natural combination in a single fund.

Sharp-eyed FundAlarm readers (you are a remarkable bunch) quickly identified the one option available to investors who don’t want to buy and periodically rebalanced separate funds. That option is a so-called “closed end” fund, First Trust/Aberdeen Emerging Opportunity (FEO).

Closed-end funds represent a large, well-established channel for sophisticated investors. There are two central distinctions between CEFs and regular funds. First, CEFs issue a limited number of shares (5.8 million in the case of this fund) while open-ended funds create new shares constantly in response to investor demand. That’s important. If you want shares of a mutual fund, you can buy them – directly or indirectly – from the fund company that simply issues more shares to meet investor interest. Buying shares of a CEF requires that you find someone who already owns the shares and who is willing to sell them to you. Depending on the number of potential buyers and the motivation of potential sellers, it’s possible for shares of CEFs to trade at substantial discounts to the fund’s net asset value. That is, there will be days when you’re able to buy $100 worth of assets for $80. That also implies there are days when you’ll only be able to get $80 when you try to sell $100 in assets. The opposite is also true: some funds sell at a double-digit premium to their net asset values.

Second, since you need to purchase the shares from an existing shareholder, you need to work through a broker. As a result, each purchase and sale will engender brokerage fees. In general, those are the same as the fees the broker charges for selling an equivalent amount of common stock.

The systemic upside is CEFs is that they’re easier to manage, especially in niche markets, than are open-end funds. Mass redemptions, generally sell orders arriving at the worst possible moment during a market panic, are the bane of fund managers’ existence. At the exact moment they need to think long term and pursue securities available at irrational discounts, they’re forced to think short term and liquidate parts of their own portfolios to meet shareholder redemptions. Since CEF are bought and sold from other investors, your greed (or panic) is a matter of concern for you and some other investor. The fund manager is insulated from it. That makes CEF popular instruments for using risky strategies (such as leverage) in niche markets.

What are the arguments for considering an investment in FEO particularly? First, the management team is large and experienced. Aberdeen boasts 95 equity and 130 global fixed income professionals. They handle hundreds of billions of assets, including about $30 billion in emerging markets stocks and bonds. Their Emerging Markets Institutional (ABEMX) stock fund, run by the same equity team that runs FEO, has beaten 99% of its peers over the past three years (roughly the period since inception). Their global fixed income funds are only “okay” while their blended asset-allocation funds are consistently above average. Given that FEO’s asset allocation shifts, the success of those latter funds is important to predicting FEO’s success.

Second, the fund has done well in its short existence. Here’s a quick comparison on the fund’s performance over the past three years. The net asset value performance is a measure of the managers’ skill, the market performance reflects the willingness of investors to buy or sell as a discount (or premium) to NAV, while the FundAlarm Emerging Markets Hybrid returns represent a simple 50/50 split between T. Rowe Price Emerging Market Stock fund and Emerging Markets Bond.

FEO at NAV FEO at market price FundAlarm E.M. Hybrid
2007 12.8 15.6 24
2008 (41) (34) (40)
2009 94 70 60
2010 29.5 23.5 15

FEO’s three-year return, through October 2010, is either 15.4% (at NAV) or 10.4% (at market price). That huge gap represents a huge opportunity, since shares in the fund have been available for discounts of as much as 30%, far above the 3-4% seen in calmer times. And both of those returns compare favorably to the performance of Matthews Asian Growth and Income (MACSX), a phenomenal long-term hybrid Asian investment, which returned only 3.5% in the same period.

Bottom Line

I would really prefer to have access to an open-end fund or ETF since I dislike brokerage fees and the need to fret about “discounts” and “entry points.” That said, for long-term investors looking for risk-moderated emerging markets exposure, and especially those with a good discount broker, this really should be on your due diligence list.

Fund website

First Trust/Aberdeen Emerging Opportunity

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