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Eversource Energy (ES) James J. Judge on Q1 2016 Results – Earnings Call Transcript

Eversource Energy (NYSE: ES ) Q1 2016 Earnings Call May 05, 2016 9:00 am ET Executives Jeffrey R. Kotkin – Vice President-Investor Relations James J. Judge – President & Chief Executive Officer Philip J. Lembo – Senior Vice President, Chief Financial Officer and Treasurer Leon J. Olivier – EVP-Enterprise Energy Strategy and Business Development Analysts Michael Weinstein – UBS Securities LLC Travis Miller – Morningstar, Inc. (Research) Caroline V. Bone – Deutsche Bank Securities, Inc. Operator Good morning, and welcome to the Eversource Energy First Quarter Earnings Conference Call. My name is Brandon, and I’ll be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note this conference is being recorded. And at this time, I will turn it over Jeff Kotkin. You may begin, sir. Jeffrey R. Kotkin – Vice President-Investor Relations Thank you, Brandon. Good morning, and thank you for joining us. I’m Jeff Kotkin, Eversource Energy’s Vice President for Investor Relations. As you can see on slide one, if you’ve gone into our slides, which are on our website, some of the statements made during this investor call may be forward-looking as defined within the meaning of the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management’s current expectations and are subject to risk and uncertainty, which may cause the actual results to differ materially from forecasts and projections. Some of these factors are set forth in the news release issued yesterday. Additional information about the various factors that may cause actual results to differ can be found in our Annual Report on Form 10-K for the year ended December 31, 2015. Additionally, our explanation of how and why we use certain non-GAAP measures is contained within our news release and the slides we posted last night on the website under Presentations & Webcasts and in our most recent 10-K. Turning to slide two, speaking today will be Jim Judge, who yesterday became Eversource Energy’s President and CEO; and Lee Olivier, our Executive Vice President for Enterprise Energy Strategy and Business Development. Also joining us today are Werner Schweiger, our Executive Vice President and Chief Operating Officer; Phil Lembo, our new Senior Vice President and CFO; Jay Buth, our Vice President and Controller; and John Moreira, our Vice President of Financial Planning and Analysis. Now, I will turn to slide three and turn over the call to Jim. James J. Judge – President & Chief Executive Officer Thank you, Jeff, and thank you all for joining us this morning. I also wanted to thank many of you on our call today for the notes you’ve sent me since our announcement last month of Tom’s retirement. Tom’s record of providing value and service to customers and investors as CEO first of Boston Edison, then NSTAR, Northeast Utilities and Eversource Energy, was unsurpassed in our industry. I was both honored and tremendously excited by being our Board’s choice to succeed him. This company has a tremendous future ahead. We continue to identify investment opportunities to enable our region to successfully implement the state and federal energy policies that continue to shape our region. We also have what I consider to be the best group of 8,000 employees in the industry and a very talented and very experienced management team. I look forward to continuing to work closely with our investors as our company continues to deliver to you attractive returns by providing the highest level of service to customers. As Jeff mentioned, pleased to share with you that yesterday the Eversource Board of Trustees elected Phil Lembo as the company’s Senior Vice President, Chief Financial Officer and Treasurer. Most of you know Phil well. He’s been a key contributor for us for years. So congratulations, Phil, and I’d like you to say a few words. Philip J. Lembo – Senior Vice President, Chief Financial Officer and Treasurer Yeah. Thank you, Jim. I would echo Jim, thank you for those notes and congratulations and calls I received. So thank you very much. I know I’ve known a lot of you for many years going back to the investor relations days several years ago. But I’m looking forward to meeting those of you who I haven’t had a chance to meet yet and working with you closely over the weeks and months ahead. I know I have some big shoes to fill and I’m excited about the opportunity. Just also want to close it and say I’ll be part of the Eversource team that’s at the AGA Conference down in Naples and I hope that I’ll get to meet you in person at that event. So thank you, Jim, and I’ll turn it back to you. James J. Judge – President & Chief Executive Officer Thanks, Phil. Today, I will cover our first quarter financial results, strong operating performance results for the quarter, an update on certain transmission projects and regulatory dockets. Starting with our financial result in slide four, we earned $244 million or $0.77 per share in the first quarter of 2016, compared with earnings of $253 million or $0.80 per share in the first quarter of 2015. Both of those are GAAP numbers since we are no longer separating our merger integration costs in reporting our results. These results represent a solid start to 2016 despite the very mild weather in the first quarter. These results also support our full year EPS estimate of $2.90 to $3.05 per share as well as our long-term earnings growth rate of 5% to 7%. Our transmission segment earned $0.27 per share in the first quarter of 2016 compared with $0.21 per share in the first quarter last year. The first of two principle drivers of that increase was the absence of a $0.04 charge we recorded in the first quarter of 2015 after FERC issued its final decision in the first New England Transmission ROE complaint. The second factor was the earnings growth we are experiencing as a result of our continued investment in the reliability of the New England power grid. That rate case growth added $0.02 per share in the first quarter of 2016. On the electric distribution side, we earned $0.34 per share in the first quarter this year compared with earnings of $0.41 per share in the first quarter of 2015. Three principle factors contributed to this $0.07 per share reduction in earnings. The primary driver was the absence in 2016 of about $0.09 of benefits we realized in the first quarter last year from settling several longstanding dockets at NSTAR Electric. Milder weather in the first quarter of 2016 reduced earnings at NSTAR Electric and PSNH where distribution revenues are not fully decoupled, and that cost us about $0.02 per share. Partially offsetting those impacts were lower O&M and other items, including our second quarter 2015 accumulated deferred income tax settlement at Connecticut Light and Power. Altogether, those factors added about $0.04 per share in the first quarter. On the natural gas distribution side, we earned $0.16 per share in the first quarter this year compared with earnings of $0.18 per share in the first quarter of 2015. Warmer weather was a principle factor with lower gas revenues costing us $0.05 per share despite a nearly $16 million annualized rate increase at NSTAR Gas. We had a very cold first quarter in 2015 and a very mild first quarter in 2016. Heating degree days in the Boston area were 21% above normal in the first quarter of 2015 when NSTAR Gas did not yet have decoupling. In Connecticut, where Yankee Gas is not yet decoupled, heating degree days were about 10% below normal in the first quarter this year compared with 18% above normal in the first quarter of 2015. The weather impact was partially offset by lower O&M, a rate increase at NSTAR Gas and other factors that together added $0.03 per share to earnings. Turning from our financial results to operations, our transmission investments totaled $140 million in the first quarter of 2016, and we continue to target transmission capital investments of $911 million for the full year. As you can see on slide five, we continue to move ahead on our major reliability transmission projects across the system. We are making solid progress on our two large families of reliability projects, the Greater Boston Reliability Solutions and the Greater Hartford/Central Connecticut Solutions. We have now invested more than $130 million in those projects with many elements now completed, under construction, or before regulators for approval. By 2019, we expect to invest $900 million in these comprehensive solutions to our region’s energy – long-term reliability challenges. The New Hampshire Site Evaluation Committee has a number of projects before it, including Northern Pass. Last month, we filed our application with the Site Evaluation Committee to build the $77 million Seacoast Reliability Project in Southeastern New Hampshire. We expect a decision on our application by mid-2017, and to complete the Seacoast project by the end of 2018. We also continue to expand our natural gas delivery system in the first quarter. We’ve added about 2,500 natural gas heating customers in the first quarter, up about 20% from the 2,050 we added in the first quarter of 2015, and very consistent with our full year 2016 goal of 12,500 new heating customers. We added a 72nd town to the Yankee Gas service territory, the town of Bozrah in Eastern Connecticut. And despite the mild winter, we did have one frigid weekend around President’s Day, when both Yankee Gas and NSTAR Gas set all-time records for the amount of natural gas delivered in a single day. On February 14, NSTAR Gas delivered over 8.5% more natural gas to our customers than the previous record set back in January, 2014. Now, I will turn to our regulatory calendar in slide six. We are awaiting a decision from the New Hampshire PUC on our comprehensive settlement with numerous state officials and other parties to divest PSNH’s generating assets. To remind you, PSNH generating rate base, including under-appreciated plants, fuel and inventory, totals approximately $700 million. Any investment we have in our generation business that is not recovered through the plant sale process will be recovered through securitization. We continue to expect the entire sale and securitization process to be completed by this time next year. Moving from New Hampshire to Washington, on March 22, the administrative law judge at FERC handling complaints number two and complaint number three involving the ROEs earned by all New England transmission owners issued his initial recommendation. For the 15-month refund period ended in March 2014, the 400-page recommendation called for a base ROE of 9.59% and a cap of 10.42%. For the 15-month period ending October 2015, the decision called for a base ROE of 10.9% and a cap of 12.19%. Our currently allowed ROE is 10.57% and our current cap is 11.74%. So if the FERC were to adopt the ALJ recommendation, we would find ourselves under-reserved for the earlier refund period by $34 million after tax and over reserved for the later refund period by $8 million after tax. Because we cannot be certain how FERC commissioners will ultimately decide the case, we didn’t book any charges this quarter due to the ALJ recommendation. We will reexamine the issue as this process moves forward. If FERC were to adopt the ALJ recommendation, we would have a one-time net charge of approximately $0.08 per share. Going forward, however, we would earn a higher ROE of 10.9% compared with the current base of 10.57%. Parties to the case filed comments on the ALJ recommendation on April 21. We continue to expect the final FERC decision around the end of this year or early 2017. I should note that after six months of no additional complaints, a fourth complaint was filed this past Friday by Eastern Massachusetts Municipal Electric Companies. We await FERC action on this fourth complaint. Turning to financing, Eversource parent issued $500 million of senior notes in March, $250 million of five-year notes with a coupon of 2.5%, and $250 million of 10-year notes with a coupon of 3.35%. Proceeds were used to pay down short-term debt. The issuances were several times oversubscribed, and we’re very pleased with the rates we received. Now, I’ll turn the call over to Lee. Leon J. Olivier – EVP-Enterprise Energy Strategy and Business Development Okay. Thank you, Jim. I’ll provide you with a brief update on our major investment initiatives and then turn the call back to Jeff for Q&A. Let’s start with Northern Pass on slide eight. The review process for Northern Pass continues to move along according to schedule. March was an important month from the standpoint of receiving public input on our project. A total of seven public meetings were held around this date in the month, three by the New Hampshire Site Evaluation Committee, two by the U.S. Department of Energy, and two jointly between these two primary permitting agencies. The Site Evaluation Committee will hold two additional public meetings on some follow-up items, one later this month and another in June. April 4 was the deadline for the written comments on the draft environmental impact statement, and we expect a final environmental impact statement from the DOE in the fourth quarter of this year. On the state side, the New Hampshire SEC recently established a near-term schedule through the end of June, providing for commencement of the discovery process in mid-May. The dates are similar to what we had proposed. Under the state statute, we would expect the New Hampshire SEC to hold evidentiary hearings and issue a decision before the end of the year. We are aware that some interveners have requested a more prolonged review period, and we expect a ruling soon on those requests and establishment of a firm schedule. Assuming the final schedule is consistent with the statutory deadline, as you can see on slide nine, it would support the issuance of a presidential permit from the Department of Energy early next year and the commencement of construction shortly thereafter. We continue to see support for the project building in New Hampshire, and we were gratified by the number of favorable comments in the public meetings, particularly from the labor and business communities of New Hampshire. We believe this is a sign of growing public support for the project and the billions of dollars of benefits it will bring to New Hampshire. As stated in our February Earnings Call, we bid both Northern Pass and the Clean Energy Connect into the three-state electric RFP. Clean Energy Connect would allow 600 megawatts of carbon-free energy to flow from New York into New England. The review process for our projects and the other approximately 20 that were bid into the process continues, and we expect the states involved in the RFP, Massachusetts, Connecticut and Rhode Island, to announce the winning bids this summer. I will now turn to slide 10 and the Access Northeast project we plan to build with our partners Spectra Energy and National Grid. To remind you, Access Northeast is a $3 billion project to upgrade the existing Algonquin pipeline and add 6.8 billion cubic feet of LNG storage in Acushnet, Massachusetts, to bring firm natural gas supplies to power generators in New England. Our share of Access Northeast is 40%, or $1.2 billion. The project is designed to provide 900 million cubic feet per day of additional natural gas supplies to serve the region’s power generators during cold winter periods. That will allow up to 5,000 additional megawatts of the region’s most efficient low-cost units to remain online when winter temperatures drop, saving New England customers approximately $1.5 billion to $2 billion in a typical winter and approximately $3 billion in an extreme winter such as the 2013 and 2014 period. Access Northeast builds up the existing Algonquin footprint which already touches 60% of the power generation in New England, a percentage that will soon grow as nearly 2,600 megawatts of new proposed plants are built and connected to the project. Access Northeast allows direct last-mile deliveries to the power plants to ensure greater reliability and cost benefits. Business model is that electric utilities sign long-term contracts with Access Northeast and then retain an independent capacity manager to market that capacity to generators out of market price. Without Access Northeast, those generators are frequently without fuel to run their units during cold winter weather when the region’s existing pipeline capacity is used primarily to heat homes and businesses. If a large amount of new pipeline capacity is set aside to meet the fuel supply needs of natural gas generators, we can depend less on more costly and higher emitting coal and oil plants that typically operate when the region’s natural gas suppliers are short. We continue to make significant progress on securing and seeking approval of contracts with New England Electric distribution companies. The current status of the state reviews is on slide 11. You will recall the following in RFP this past fall, NSTAR Electric, Western Mass Electric, and two National Grid electric distribution companies filed with the Massachusetts DPU seeking approval of contracts for pipeline and storage capacity with Access Northeast. Our two utilities asked for a decision by October 1 of this year. The DPU has established a schedule to review that filing that would support a decision in the early fall. Evidentiary hearings on all of the contracts are scheduled for this summer. Once approved by the Department of Public Utilities, these contracts will account for more than 40% of Access Northeast targeted capacity. In Connecticut, we expect the State Department of Energy and Environment Protection to issue request for proposals for natural gas capacity shortly. We expect this process to be complete with approved contracts late this year or early in 2017. In New Hampshire, you may recall that the Public Utilities Commission issued an order on January 19 in which they accepted a staff report that concluded that the Public Utility Commission had sufficient authority to approve electric distribution contracts, financial gas supplies if those contracts were shown to be in customers’ interests. On February 18, Public Service of New Hampshire filed with state regulators a natural gas contract with Access Northeast that was similar to what the four Massachusetts electric utilities filed in their state. If the New Hampshire Public Utility Commissioners agree with the staff that they have sufficient authority to approve such agreements, they would then determine whether the specific contracts submitted were in the customer’s best interest. A technical session on the docket scheduled was held yesterday. We are optimistic that the commissioners will agree with the staff that they have authority to approve a contract with Public Service of New Hampshire and Access Northeast. The PUC’s consideration of whether the contracts provide benefits to customers would follow its legal ruling on the issues. In Maine, where regulators have been engaged in natural gas contracting issue for some time, state regulators are scheduled to reach a decision on recommended solutions by the early fall. In Rhode Island, National Grid issued in RFPs in the fall with bids received November 13, around the same time as the Massachusetts electric distribution companies had their RFP. We expect the National Grid to make a decision and file with Rhode Island regulators by early this summer. In Vermont, the state has expressed support for additional natural gas infrastructure, but its level of participation is yet to be determined. We expect that the state processes will be sufficiently advanced by the end of this year so that we can promptly file a formal application with FERC and bring additional natural gas supplies into New England for the winter 2018 to 2019. We continue to believe that Access Northeast offers an excellent near-term and long-term answer to the region’s intensifying winter energy challenges. And now, I’d like to turn the call back over to Jeff for any Q&As. Jeffrey R. Kotkin – Vice President-Investor Relations All right. And I’m going to turn it back to Brandon just to remind you how to answer questions. Question-and-Answer Session Operator Thank you, sir. Jeffrey R. Kotkin – Vice President-Investor Relations All right. Thank you. Our first question this morning is from Mike Weinstein from UBS. Good morning, Mike. Michael Weinstein – UBS Securities LLC Hey. Good morning. I was just wondering if we could talk about the – whether the current status of the RFPs and expected approvals for gas contracts support beginning construction in 2017 for getting major sessions with the pipe online for the winter of 2018 and 2019, generally speaking broadly. Leon J. Olivier – EVP-Enterprise Energy Strategy and Business Development Yeah, Mike. This is Lee Olivier. The construction period would start for the project in 2018, will start in early 2018, approximately the April-May timeframe and then the first sections would go in on the piping for the winter of 2018. So you’re talking about the November timeframe of 2018. I would say right now we’re still on schedule. We will be prepared to file the comprehensive filing at FERC in the November-December timeframe. We believe the timing in and around the other states, including Connecticut, even though Connecticut is built inside of their process, they have 90 days to negotiate precedent agreements with the EDCs, we think that could be done in approximately 30 days or 35 days. Their approval process through their regulatory body PURA is a very short term, it’s about 60 days. So we think all of these schedules line up right now for conclusion by the end of this year and filing with FERC and start with construction in the spring of 2018 for the first phase of the pipeline. Michael Weinstein – UBS Securities LLC Are you seeing more support for the project, just broadly speaking, as a result of the cancellation of Northeast Energy Direct? Leon J. Olivier – EVP-Enterprise Energy Strategy and Business Development I would say, although, the two projects were designed somewhat differently, we were designed to supply gas to generators to firm up 5,000 megawatts and they – ostensibly the (24:55) all around providing LDC power supplies. I think the fact that they’re not going to be there obviously puts more pressure on the overall gas supplies of the region. So I believe that there is more support firming up around Access Northeast, both in the business community and with policymakers as well. Michael Weinstein – UBS Securities LLC And just one last one. Can you give us an update on Massachusetts legislation and work for renewables in the state, how that might impact things like the Clean Energy Connect project, things like that? James J. Judge – President & Chief Executive Officer Sure, Mike. This is Jim. We had solar legislation that was approved in Massachusetts that increases that needling cap and actually extends the opportunity for utilities to consider a utility-owned solar. There is also proposed legislation that the governor is endorsing which recommends hydroelectric commitments as well as offshore wind is being discussed as well. Those are only in draft form of proposed, it’s only until the solar legislation is passed today. Michael Weinstein – UBS Securities LLC Okay. Thanks a lot. Jeffrey R. Kotkin – Vice President-Investor Relations All right. James J. Judge – President & Chief Executive Officer Thank you. Jeffrey R. Kotkin – Vice President-Investor Relations Thanks, Mike. Our next question this morning is from Travis Miller from Morningstar. Good morning, Travis. Travis Miller – Morningstar, Inc. (Research) Good morning. Thanks. I was wondering just on the demand, so electric demand in particular. How much of that was weather do you estimate? I know it’s tough to do. James J. Judge – President & Chief Executive Officer Travis, it’s a tough question because you have such an extreme change from one year to the next, a very, very cold winter in the first quarter, a very mild winter this quarter resulting in a sales decline in the electric side of 8.5%. I would say that virtually all of that is weather-driven. I think without the – if we had had normal weather, I think the sales would have been close to flat, is my estimate. Travis Miller – Morningstar, Inc. (Research) Correct. Is that – remind me what your outlook is for this year in terms of electric sales growth. James J. Judge – President & Chief Executive Officer Flat is the estimate that we provided. Travis Miller – Morningstar, Inc. (Research) Okay. And is that – if we look out, call it five years or something, what kind of trends are you seeing in terms of what would keep electric demand flat or 0.5%, something well below what we’ve seen historically? Are there particular specific trends and programs perhaps that you would see depressing that type of demand? James J. Judge – President & Chief Executive Officer Yeah. We’re estimating the long-term growth rate on the electric side to be flat as well. As you know, we are decoupled in a number of our franchises. And as we have future rate cases, we’ll be decoupled everywhere, I expect. But we are forecasting flat on the electric side, but because of the gas conversions going on, we think there’ll be 2% to 3% growth in gas sales annually. And really I think the primary driver to that flat growth has got nothing to do with the economy, in particular in the Boston area the economy is moving. There’s lots of construction going on. But we as a company spend $500 million a year, $0.5 billion a year on energy efficiency, and I think that has a significant impact – 2% impact on the sales results for the company. Now, fortunately, the rate-making mechanism for energy efficiency spending makes us whole, either decoupling our loss-based revenues reimburse us. If we actually do a good job on the projects, we’re able to earn an incentive. And at the same time, we’re recovering our costs as we incur them each year. So the cash flow is positive as well. So, yeah, were it not for energy efficiency, I think we’d be looking at 2% or higher sales volume growth. Travis Miller – Morningstar, Inc. (Research) Okay, great. I appreciate the thoughts. Thanks. Jeffrey R. Kotkin – Vice President-Investor Relations Thank you, Travis. Our next question is from Caroline Bone from Deutsche Bank. Good morning, Caroline. Caroline V. Bone – Deutsche Bank Securities, Inc. Hey. Good morning, and first of all congratulations, Jim and Phil. That’s wonderful news. James J. Judge – President & Chief Executive Officer Thank you very much. Philip J. Lembo – Senior Vice President, Chief Financial Officer and Treasurer Thank you. Caroline V. Bone – Deutsche Bank Securities, Inc. You’re welcome. So I just have one question. Last call, I believe you guys discussed the possibility of share buybacks. And I was just wondering if you could kind of review with us the circumstances in which we might see such a program? James J. Judge – President & Chief Executive Officer Sure. We have a lot of positive cash flow items, right? Our fundamental business is strong to begin with. We’ve got bonus depreciation that’s been extended. We have $700 million of cash coming in the door next year from the divestiture and securitization. And what we have said in the past is that to the extent that we can’t find additional projects to pursue, to redeploy that cash, ultimately it’s shareholders’ monies and so obviously we would pay off some debt as well. But we would consider a share buyback if there wasn’t a better use of the proceeds. That being said, I wouldn’t expect any announcement this year. I mean, we are certainly executing to our plan for 2016. As we reaffirm guidance today, we continue to believe that we’re going to be able to achieve those results and those results for 2016 do not assume a buyback is in place. Caroline V. Bone – Deutsche Bank Securities, Inc. Okay. Thank you. That’s very clear. Jeffrey R. Kotkin – Vice President-Investor Relations Thanks, Caroline. We don’t have any other questions this morning. So we want to thank you for joining us. We look forward to seeing you at many conferences over the next couple of weeks, and have a good rest of the day. Operator Ladies and gentlemen, this concludes today’s conference. Thank you for joining. You may now disconnect. Jeffrey R. Kotkin – Vice President-Investor Relations Thanks, Brandon. Operator You bet. Take care. Jeffrey R. Kotkin – Vice President-Investor Relations All right. 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The Ins And Outs Of Municipal Closed-End Funds

Given the likely continuation of the record low fixed income yield environment for the foreseeable future, potential periods of heightened, future stock market volatility and attractive current yields versus comparable taxable investments, municipal bonds and municipal bond-oriented investment strategies, including closed-end funds , have been in high demand of late. For example, as you will see from the table below, all U.S. Traded Tax-Free National Muni Bond CEFs are now trading, on average, above their 10 year average premium/discount. This has not been the case in the last two years. Click to enlarge Source: Wells Fargo Advisors/Morningstar as of April 14, 2016 . In addition, with respect to municipal bond-focused mutual funds, U.S. Municipal bond funds recently posted their 28th consecutive week of inflows. Consider the mutual fund flow information for Municipal Bond funds relative to Taxable Bond funds below from the Investment Company Institute’s (ICI) Trends in Mutual Fund Investing report for the first two months of 2016. Mutual Fund Classification February 2016 January 2016 January – February 2016 January – February 2015 Domestic Equity -3,330 -15,480 -18,809 8,376 World Equity 10,820 10,507 21,326 13,599 Hybrid -1,457 -10,639 -12,096 6,057 Taxable Bond -3,980 -9,425 -13,405 19,914 Municipal Bond 4,690 4,269 8,959 7,230 Taxable Money Market 44,925 -10,874 34,051 -45,488 Tax-exempt Money Market -7,642 -9,372 -17,013 -2,039 Total 44,026 -41,013 3,013 7,649 Overall, the strong demand for, and low underlying supply of, municipal bonds have kept prices high and yields relatively low during the first quarter, yet I would anticipate demand remaining high for municipal bond-oriented investment strategies for the balance of 2016. As a result, for those interested in adding, or increasing, allocations to municipal bonds through CEFs to their client portfolios, the following overview of the municipal bond CEFs may prove helpful. At present, there are 176 closed-end funds in the Tax-Free Income category outstanding across 19 different strategies; some national and some state specific, according to CEFConnect.com. Category Strategy # of CEFs Tax-Free Income High Yield 6 Tax-Free Income National 88 Tax-Free Income (State) Arizona 2 Tax-Free Income (State) California 22 Tax-Free Income (State) Connecticut 1 Tax-Free Income (State) Florida 1 Tax-Free Income (State) Georgia 1 Tax-Free Income (State) Maryland 2 Tax-Free Income (State) Massachusetts 4 Tax-Free Income (State) Michigan 4 Tax-Free Income (State) Minnesota 2 Tax-Free Income (State) Missouri 1 Tax-Free Income (State) New Jersey 8 Tax-Free Income (State) New York 21 Tax-Free Income (State) North Carolina 1 Tax-Free Income (State) Ohio 3 Tax-Free Income (State) Pennsylvania 6 Tax-Free Income (State) Texas 1 Tax-Free Income (State) Virginia 2 Since CEFs contain their own unique set or risk considerations, including but not limited to the utilization of leverage, it is critical in my view to employ a comprehensive set of selection criteria beyond just looking for those CEFs that have the highest current yield and/or are trading at the deepest discount relative to their own net asset value (NAV). In this regard, some of the screening criteria that we consider at SmartTrust® when selecting municipal CEFs for our applicable unit investment trust (UIT) strategies include, but is not limited to, the following: · Market Cap & Liquidity – measured by total net assets, in U.S. dollars, and average trading volumes of the CEF. We generally look for CEFs with total net assets of $100mm or greater, while also giving consideration for average trading volume. · Distribution Rate – this is the current distribution rate, or yield, of the CEF and is a measure of the current annualized distribution amount divided by the current price – not the NAV. · Distribution Amount – most current cash distribution amount per share. We are only interested in looking at regular income distributions and disregard returns of principal, special (i.e. non-regular) distributions, short term capital gains and long term capital gains. · Earnings per Share (EPS) – this is the most current amount that the CEF earned per share. We generally exclude those CEFs with negative earnings per share. · Earnings/Distribution Coverage Ratio – this ratio compares current earnings to current monthly distribution amounts where ratios over 100% indicate that the CEF is “over-covered” from an earnings/distribution standpoint and ratios under 100% indicate that the CEF is “under-covered” from an earnings/distribution standpoint. We prefer CEFs that have a high Earnings/Distribution Coverage Ratio. · Undistributed Net Investment Income (UNII) – the life-to-date balance of a fund’s net investment income less distributions of net investment income. UNII appears in shareholder reports as a line item on a fund’s statement of changes in net assets. We consider UNII as a cash buffer or a cash reserve to a CEF portfolio. We typically do not consider CEFs with negative UNII balances. · UNII/Distribution Coverage Ratio – this ratio compares current UNII balances to current monthly distribution amounts to determine how many months of distribution coverage are covered by the CEF’s UNII balance. · Premium / (Discount) -the amount which a closed-end fund market price exceeds (premium) or is less than (discount) the net asset value of that CEF. We contend that a CEF trading at a premium does not necessarily mean it is overvalued and a CEF trading at a discount is not necessarily undervalued. There is nothing written in stone that states that a closed-end fund (CEF) ever has to trade at its net asset value. · 52 Week Average Premium / (Discount) – to help gauge the relative value of the current premium / (discount) of a given CEF, we compare the current to premium / (discount) to the 52 week average premium / (discount). Such comparisons are done not only for the CEF itself but also in relation to their category/strategy. For example, CEFs trading below their 52 week averages represent greater relative value to us than those CEFs trading above their 52 week averages. · Effective Leverage ( and type of leverage employed ) – total economic leverage exposure of the CEF and includes structural leverage, which is calculated using leverage created by a fund’s preferred shares or debt borrowings by the fund, as well as leverage exposure created by the fund’s investment in certain derivative investments (including, but not limited to, reverse repurchase agreements). Leverage is typically represented as a percentage of a fund’s total assets. Given the current record low interest rate environment, many CEF managers are still currently employing some form of leverage to enhance their portfolio yields and take advantage of low relative borrowing costs. For example, approximately 97% of all tax-free income CEFs currently employ some form of leverage. Recognizing that portfolio leverage may increase the volatility of a given CEF and leverage itself can provide less value when short-term rates approach or exceed long-term rates, we pay careful attention to the type and amount of leverage that each CEF strategy employs, especially as we are now within what is likely to be a protracted period of gradually rising interest rates. · Expense Ratio – it is important to be cognizant of the effect that the underlying CEF expense ratios have on the overall portfolio performance of the strategy. · Credit Quality – most CEF sponsors report the credit quality breakdown of the underlying bond holdings within their portfolios at different reporting periods. · Maturity – most CEF sponsors report the maturities of the underlying bond holdings within their portfolios at different reporting periods. · Option Adjusted Duration (OAD) – while all CEF sponsors do not necessarily report the OAD of the underlying bond holdings within their portfolios at different reporting periods, financial software providers, such as Bloomberg, do calculate and provide this interest rate sensitivity based information. · AMT Percentage – most CEF sponsors report the AMT percentages of the underlying bond holdings within their portfolios at different reporting periods. This information may be helpful for portfolios allocations to high new worth clients who are within a higher tax bracket. · % of Portfolio Pre-refunded – most CEF sponsors report the percentage of their portfolios that are pre-refunded related to the underlying bond holdings within their portfolios at different reporting periods. We generally look favorably on pre-refunded bonds. To appreciate our perspective, it is necessary to understand how pre-refunded bonds work. Pre-refunded bonds are issued to fund another callable municipal bond, where the issuer of the municipal bond actually decides to exercise its right to buy its bonds back before the bond’s scheduled maturity date. The proceeds from the issue of the lower yield and/or longer maturing pre-refunding bond will usually be invested in U.S. Treasury bills until the scheduled call date of the original bond issue occurs, thereby reducing the credit risk of the original bond issuance. While no screening criteria can guarantee the success of a selected investment strategy, I believe that the multi-factor approach described above can be helpful in uncovering municipal CEFs that strive to pay high, sustainable levels of tax-free income, and provide for total return potential, over the life of each CEF investment strategy. Disclosure: Hennion & Walsh is the sponsor of SmartTrust® Unit Investment Trusts (UITs). For more information on SmartTrust® UITs, please visit smarttrustuit.com . The overview above is for informational purposes and is not an offer to sell or a solicitation of an offer to buy any SmartTrust® UITs. Investors should consider the Trust’s investment objective, risks, charges and expenses carefully before investing. The prospectus contains this and other information relevant to an investment in the Trust and investors should read the prospectus carefully before they invest. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Quit Calling It Smart Beta

Click to enlarge Image source: istockphoto.com. Used with permission. Quit Calling It Smart Beta Last week, an advisor forwarded me this Financial Times article, ” Smart Beta Not Quite as Clever as Marketed ,” asking for my comment, to which I immediately responded, “the only aspect of the article I agree with is the title.” Since arriving at 3D Asset Management, I’ve published two articles on ETF investing: ” ETF Product Development: Innovation Versus Over-Engineering ” and ” Why ETFs (and Why Strategic Beta ETFs) .” In both these articles, I have advocated for our use of factor-based ETFs, commonly known as alternative beta or strategic beta. Despite what appears to be an industry-wide adoption of the term, I refuse to use the label ‘smart’ beta for factor-based ETFs. Here is what I wrote in “ETF Product Development:” …’smart’ beta (factor) investing is not ‘smart’ at all but just a reformulation of the Dimensional Fund Advisors’ (DFA) strategy of investing in areas of the market which have afforded higher risk premia over the long run. ‘Small cap’ and ‘value’ factors outperform over the market because they come with higher risks which investors are compensated for over the long run – these factors are no ‘smarter’ than a traditional market-cap based approach such as the S&P 500. ‘Smart beta’ is a marketing label used by ETF sponsors to get advisors more comfortable with alternative methods of indexing. But it is no more nefarious than that, unlike what is implied by the Financial Times article critiquing factor ETFs. The rollout of strategic or alternative beta ETFs reflects innovation on the part of ETF and index providers to give retail investors access to market segments and themes historically only available to professional/institutional investors. What follows is a section-by-section critique of the FT article: Has the investment industry’s marketing push outsmarted itself? For several years, huge effort has gone in to selling “smart beta” funds. It has worked, creating great excitement. Now, not at all surprisingly, the backlash has begun. 3D’s Response: “Backlash” from whom? From those most threatened by the advent of factor-based ETFs? Strategic beta ETFs capture much of the systematic elements of many actively-managed strategies in cost-effective and tax-efficient vehicles. So who feels most threatened by this wave of product innovation? That is, of course, rhetorical. Smart beta comes up with a strategy to beat the index, which can itself be made into an index with simple rules. The advantage of doing this is that funds that track an index can be run far more cheaply than active funds, which face a far higher bill for research and managers’ salaries. So if a winning strategy can be reduced to an index, it should be possible to cut costs, and offer a superior return to investors . 3D’s Response: Agree with most of this statement, except this notion of “winning.” The goal of investing isn’t to ‘win’ but to achieve long-term financial goals, whether with indexing or with active management. If the focus is just on ‘winning’, then one misses the entire point of investing in the first place. For instance, a dividend-focused strategy is designed not so much to outperform the broad market-based benchmark (i.e. the S&P 500) but to provide investors with desired portfolio characteristics, namely 1) total returns sourced more from dividend income than capital appreciation and 2) lower equity market sensitivity. Does this strategy ‘lose’ if it delivers on this objective even though it may underperform the market-based benchmark? Smart beta strategies are now proliferating but most commonly stem from anomalies identified in the academic literature. Perhaps most importantly, there are Value (cheap stocks do better than expensive), Momentum (winners keep winning, and losers keep losing), and Low volatility (relatively stable stocks perform better). All will have periods when they do badly. All perform well in the long run. Other popular strategies involve weighting portfolios by companies’ sales, or revenues, or dividends . From these building blocks, investment managers have now built multifactor funds in different proportions, and come up with a dizzying array of new factors. And they have sold a lot of funds on the back of it. 3D’s Response: As a former quantitative portfolio manager, I can reasonably say that most of the historically effective factors are now captured in some form by ETF products. I don’t know what the true library of significant and investable factors consist of, but I am confident it is between the three originally proposed by Fama/French (market, size, value) and somewhere in the range of 15-20. But is it a “dizzying” array? First, one must distinguish between an ETF that captures an historical risk premium or anomaly such as value or momentum versus an ETF built on rules designed to capture a specific investment theme such as Goldman Sachs Hedge Fund VIP ETF which would screen for top hedge fund holdings of individual stocks. Second, the ‘dizzying’ array of factors is partly driven by legitimate differences on what is the best rule-based design to capture a factor. Strategic betas such as value and quality can be defined differently, but many of them achieve similar results. ETF strategists such as ourselves conduct due diligence to get underneath the hood on what the factor is trying to achieve and then provide research opinions on whether a particular ETF provides the best rules-based design given the cost. But there is a problem. In theory, and in practice, once a market anomaly has been observed, it cannot continue. There are two reasons why future performance may be worse than the historical backtest suggests, outlined by Pete Hecht, chief market strategist for Evanston Capital Management, in a recent paper. First, the back-test may have been “data-mined.” In other words, the researchers fiddled to find a formula that delivered the very best result for the period they were looking at. This may be due to dishonesty, or may happen unconsciously. 3D’s Response: First, a straw man warning. Pete Hecht from Evanston may be correct in his observation of Fama/French, but some disclosure should have been made that Evanston has a vested interest in dismissing smart beta as a flash in the pan fad since Evanston serves as a multi-manager hedge fund-of-fund, whose value proposition (along with much of traditional active management) is under competitive threat from strategic beta investing. That said, Hecht’s first argument is facetious at best and indicts any data-driven approach to investing. There are clear standards for what constitutes robust backtesting, namely is the observed factor anomaly consistent, robust, and reliable across time and across different markets? There is ‘true’ data mining which is to throw as much stuff on the wall and see what sticks and there is robust backtesting where there is a clear and intuitive rationale for the observed behavior. A second problem is arbitrage, and the very existence of smart beta funds feeds this problem. Once you know that cheap stocks outperform, the logical response is to buy cheap stocks. If many do this, cheap stocks’ price will rise until they no longer outperform. 3D’s Response: This ignores the fact that underlying factor behavior is a risk-premium or behavioral explanation. ‘Arbitrage’ implies there exists some systematic mispricing between two or multiple assets and that a well-functioning market should reduce this mispricing such that it cannot be exploited over a sustained period of time. However, those who hold to a risk premia view of factor investing believe such premia exist precisely due to rational pricing on the part of investors. Take the value risk premium as an example. As Fama/French originally argued in their 1992 paper, ” The Cross-Section of Expected Stock Returns ,” the value effect (as proxied by book value/market value ratio) is “the market’s assessment of its value [which] should be a direct indicator of the relative prospects…” In other words, ‘cheap’ stocks are cheap for a reason, because they are riskier than the overall market. Cheap stocks tend to be financial companies that trade close to book value due to regulatory or financial leverage reasons or companies with highly cyclical (and uncertain) earnings that the market is not willing to assign a premium multiple to. I won’t delve into the rationales driving the other main factor categories, but the historical size and value risk premia as documented by Fama/French are rooted in highly intuitive economic rationales and not the result of some creative backtests with no fundamental rooting as implied by the FT article. Mr. Hecht took Mr. Fama’s formulas for determining which stocks were cheap, and saw how the strategy would have performed starting in 1992 and carrying on to the present. In all cases, whether measured by straight performance or adjusted for risk, they did much worse after the paper’s publication than they had before it. The reduction in performance ranged from 30 to 71 percent. The value effect had diminished. 3D’s Response: There is some evidence that the long-term risk premium has shrunk as market participation has expanded and has become more electronic and global. However, Mr. Hecht’s observation wouldn’t just apply to the value premium but to the entire market risk premium itself. If equity market investing has become less ‘risky’ then investors should expect to be compensated with less return over time. But common sense intuition would hold that equities are riskier than bonds over the long run and that risk can fluctuate during different economic and inflationary cycles. Otherwise the entire notion of rational capital pricing would collapse into absurdity. No one would suggest that the equity risk premium should go to zero (except these guys ) just because the markets have gotten more efficient. Likewise, few would argue that small cap stocks should not trade at a premium versus large cap stocks (i.e. would you be willing to accept the same premium for holding Pfizer (NYSE: PFE ) than you would a small, speculative biotech?). And the same holds for value stocks as mentioned above. However, Hecht’s second argument brings up broader implications for active management. If there is a diminishing return to value and small cap investing (and it’s debatable since size and value have shown long-term persistency across multiple markets), then this would have profound implications for all of active management, not just strategic beta. Hecht’s arguments of diminishing returns to factor investing has even worse implications for traditional active management and hedge funds where much of the alpha they provide can be sourced from such systematic factors. As more active managers and hedge funds become ‘discovered’ and ‘popular’, then presumably their edge in delivering alpha should also be reduced. That leads to another problem, identified by Rob Arnott in a paper for Research Affiliates, a pioneer of smart beta. A strong backtest at any point in time, he reasons, may be because the factor tested has become expensive. Very perversely therefore, a strong backtest almost becomes a reason not to buy into a strategy. And if a strategy looks good now simply because it is expensive, that may be an active reason to fear that it will now perform badly. Conversely, it might imply that factors that have done poorly of late – and as the chart shows, value has badly lagged behind the market ever since the financial crisis – are now cheap and worth buying, for those with the intestinal fortitude to do so. Meanwhile it is worth checking whether low-volatility and high-momentum stocks, both still performing well, look over-expensive and due to revert to the mean. 3D’s Response: Are there more opportunistic times to buy factor portfolios like value? Sure, that’s almost axiomatic. Buying value seemed to be the only strategy that worked in 2009 following the steep sell-off during the global financial crisis, but when it looked like large banks like Citigroup (NYSE: C ) and Bank of America (NYSE: BAC ) would go under, it would have required heroic “intestinal fortitude” to bet on value at the height of uncertainty. When a long-term strategy looks especially cheap versus its history, then it will likely have a higher payoff if you believe in the long-term rationale for owning that strategy in the first place. I find it interesting that Research Affiliates is now just commenting on this after an especially tough period for the RAFI indices, notably in emerging markets. Despite de-emphasizing the role of ‘price’ in its construction, RAFI has historically correlated with value-style indices. One rarely hears from value managers to avoid their strategies because the underlying valuation spreads are narrow (and less opportunistic to buy into the strategy). During these moments when valuation spreads were narrow, chances are the prospective investor had been regaled with Morningstar ratings on past performance, sort of like the backtests Research Affiliates is critiquing. I do believe factor (and strategy) timing is difficult, particularly if one uses valuation spreads as part of the allocation process. Please see this article published by Larry Swedroe on ETF.com where he summarizes research questioning the use of valuation as a timing tool for factor selection. However, I would not rule out valuation as a reason to avoid a factor or to opportunistically invest in it; it is a matter of perspective and what other aspects are incorporated into the decision-making. The bottom line is that investment processes incorporating strategic beta ETFs should not bet on one or two factors but should be diversified across a variety of factors so as to minimize the disruption due to valuation conditions. A final issue: risk. Piling into one particular factor is inherently more risky. For Andrew Lo of Massachusetts Institute of Technology, one of the world’s most respected financial theorists, the problem with “smart beta” is that it can easily morph into “dumb sigma” – the Greek letter used for volatility. 3D’s Response: This is awkwardly written. Yes, investing in just one factor is riskier than being diversified across multiple factors. Yet, how does this morph into “dumb sigma?” Many things can lead to “dumb sigma.” Buying equity on margin can be considered “dumb sigma.” “Dumb sigma” just reflects poor portfolio construction and risk control and is not necessarily indicative of strategic beta investing. The main takeaway is that alternative / strategic beta ETFs have given retail investors more options than what has been historically available. These are not a panacea for beating the markets but can serve as cost-effective to gain targeted exposures not directly accessible via traditional market indices. The goal is not to “win” but to build more robust portfolios to achieve long-term investment goals and objectives. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.