One of the appealing attributes of closed-end funds (CEFs) is the potential to buy shares at a discount to their net asset value (NAV). CEFs frequently trade at discounts. In volatile markets, such as the ones we’ve been experiencing, discounts can widen significantly, offering investors the opportunity to purchase shares well below their NAV. However, this can be a risky strategy if based on the assumption that the fund’s discount will narrow over the investor’s timeframe. It also ignores the primary historical contributor to CEF returns: distributions.
What causes a CEF to trade at a discount or premium?
A CEF’s market price is largely determined by demand and supply. Similar to a stock, demand for a CEF is affected by market dynamics, investor sentiment and quantitative and qualitative factors about the fund. Supply is simply the amount of shares offered for sale by existing shareholders, who are also affected by the same factors that drive demand. The difference between the market price, which typically fluctuates throughout the trading day, and the NAV — the per-share value of the underlying portfolio, calculated once daily — is expressed as a premium or discount percentage relative to NAV. For example, a fund trading at a price of $18 per share with a $20 NAV is said to be trading at a 10% discount. If the fund’s market price is $21 per share, it’s trading at a 5% premium to NAV. Why might the market pay more than the NAV for shares of the fund? There may be few or no good substitutes for the fund, such as a fund invested in municipal bonds exempt from tax in a particular state where the supply of bonds that qualify for this exemption is limited. The fund may be a newly-developed investment strategy investors are eager to access, it may be managed by a highly-regarded manager, or it is paying higher distributions than other similar funds. Any or all of these and other factors could cause a fund’s shares to trade at a premium.
Conversely, a fund may be trading at a discount due to poor fund performance, or low distribution levels relative to peers or to market expectations. Or, current performance may be acceptable, but the market may forecast that a fund’s future earnings or distribution potential is limited or declining, and may therefore bid share prices downward in anticipation of future bad news. Sometimes, however, there may be strong selling pressure that drives the share price down without any discernible reason related to the actual fund.This can happen with any exchange-traded product. Market fear can prompt investors to sell, which will temporarily flood the market with supply. If a fund is caught up in this “herd mentality,” but its future earning potential seems solid, such a price drop may be temporary. This may be a good opportunity to purchase shares, if the fund’s strategy and performance match an investor’s needs.
When evaluating CEFs, investors may do well to focus less on discounts and more on fund distributions and the primary role distributions have played in longer-term total return.
Understanding the sources of CEF returns
Another important factor to consider when evaluating CEFs is that distributions — not discounts — have historically been the primary contributor to total returns over longer periods of time.
CEFs are designed with the goal of providing attractive, regular distributions — and have long been valued for the income stream and diversification benefits they may offer. While CEF distributions would be expected to positively contribute to returns, over longer periods distributions become an increasingly larger positive component of total return while the change in discounts contribute increasingly less to total return. In other words, the opportunity to benefit from a narrowing discount has historically diminished over time to be a negligible contributor to overall total return while distributions (funded by NAV total return) become the dominant component.
Therefore, investors may be better served by focusing on a fund’s distribution and NAV performance. How much is the fund paying? What is the distribution composed of and how does the distribution rate compare to the fund’s NAV performance over relevant time periods? Is the NAV return sufficiently high to pay the current distribution? Does performance seem reasonably sustainable over your time horizon?
Of course these are just a few factors to consider when deciding whether to buy a particular fund. But answering these questions, as well as assessing a fund’s pricing relative to historical trends, can help investors better determine whether a fund trading at a discount may be undervalued and an attractive buying opportunity.
A word on risk
It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund’s investment objective will be achieved. Closed-end fund shares may frequently trade at a discount or premium to their net asset value (NAV).
Closed-end fund historical distribution sources have included net investment income, realized gains, and return of capital. Leverage increases return volatility and magnifies a fund’s potential return whether that return is positive or negative. There is no guarantee a fund’s leveraging strategy will be successful. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time.
FAQs
Many investors prefer purchasing closed-end funds at a wide discount because purchasing at a discount increases a fund's distribution rate and may present a higher potential for capital appreciation if the discount narrows due to the price rising to NAV.
How do you tell if a closed-end fund is trading at a discount? ›
Shares are said to trade at a "discount" when the share price is lower than the NAV. The discount is commonly denoted with a minus ("−") sign.
Why do close ended funds trade at a discount? ›
Conversely, a fund may be trading at a discount due to poor fund performance, or low distribution levels relative to peers or to market expectations.
Why some close ended funds are quoted at a discount to their NAV? ›
While the Net Asset Value (NAV) of the fund determines its actual price, the traded price can be above or below this value depending on demand and supply of the units. Typically, these close ended funds trade at a discount to the NAV to factor in costs.
What are the pros and cons of closed-end funds? ›
Closed-end fund: pros & cons
| Pros | Cons |
|---|
| Exchange-traded Price determined by market supply and demand Higher potential returns than open-end funds | Can be less liquid Greater volatility Losses can be magnified due to leverage |
Nov 30, 2023
The basics of premiums and discounts
When the market price of a CEF is above its net asset value (NAV), the fund is said to be trading at a premium. Conversely, when a fund's market price is below NAV, the CEF is trading at a discount.
How do you know if a stock is trading at a discount? ›
If the net asset value per share is higher than the share price, an NAV discount is said to exist. If the NAV is lower than the share price, the shares are said to trade at a premium to NAV. Shares in less popular investment companies trade at a discount to NAV.
What is the closed end discount puzzle? ›
The closed end fund puzzle is the empirical finding that closed end fund shares typically sell at prices not equal to the per share market value of assets the fund holds.
When should I buy closed-end funds? ›
BlackRock believes that it may be advantageous to purchase a fund when it is trading at a discount to its NAV, as each dollar invested purchases more than a dollar of net assets. If the discount begins to narrow, investors may also have greater potential for capital appreciation.
What is a closed end discount puzzle? ›
closed-end fund puzzle is the empirical finding that closed-end fund shares. typically sell at prices not equal to the per share market value of assets the. fund holds. Although funds sometimes sell at premia to their net asset. values, in recent years discounts of 10 to 20 percent have been the norm.
Once the shares are sold and the issuer collects the IPO proceeds, the fund's shares trade in the secondary market between investors. Therefore, closed-end funds are negotiable securities.
What does it mean for a closed-end fund to trade at a discount What does it mean for a closed-end fund to trade at a premium? ›
Closed-End Funds and Net Asset Value (NAV)
However, the price that it trades for on the exchange is market-driven. This means a closed-end fund can trade at a premium or a discount to its NAV. A premium price means the price of a share is above the NAV, while a discount is the opposite, below the NAV.
Is discount to NAV good or bad? ›
If the share price is lower than the NAV per share, the investment trust is trading at a discount. This means the investment trust isn't as popular and the demand for the shares isn't as strong. If the share price and NAV per share are equal, the investment trust is trading 'at par'.
Why not to buy closed-end funds? ›
Because closed-end funds are often actively managed by an investment manager who is trying to beat the market, they may charge higher fees, making them less attractive to investors. Closed-end funds frequently use leverage — borrowing money to fund their asset purchases — to increase returns.
Why would anybody want to invest in a closed-end fund? ›
The higher risk involved with investing in illiquid securities could translate into higher returns to shareholders. Second, regulators allow the funds to issue debt and preferred shares, with strict limits on leverage. The fund can issue debt in an amount up to 50% of its net assets.
Why do people buy closed-end funds? ›
Fixed-income investors are often attracted to closed-end funds because many provide a steady stream of income, usually on a monthly or quarterly basis as opposed to the biannual payments provided by individual bonds.
What are discounted closed-end funds? ›
Closed-end funds often sell at massive discounts to net asset value (NAV). In these cases, they're effectively worth more dead than alive! Another nice aspect of CEFs is that, unlike mutual funds, they can use debt leverage to juice their returns.
What is the trading characteristic of a closed-end fund? ›
A closed-end fund generally does not continuously offer its shares for sale but instead sells a fixed number of shares at one time. After its initial public offering, the fund typically trades on a market, such as the New York Stock Exchange or the NASDAQ Stock Market.
Do closed-end funds always trade at their net asset value? ›
Unlike open-end funds, however, closed-end funds do not trade at their NAVs. Instead, their share prices are based on the supply of and demand for their funds and other fundamental factors. Consequently, closed-end funds can trade at premiums or discounts to their NAVs.
What does trading at a discount to NAV mean? ›
If the share price is lower than the NAV per share, the investment trust is trading at a discount. This means the investment trust isn't as popular and the demand for the shares isn't as strong. If the share price and NAV per share are equal, the investment trust is trading 'at par'.
