Closed-end funds are odd ducks. They are very different from the more familiar open-end mutual funds. CEFs resemble exchange-traded funds. Both are stocks with a fixed number of shares that investors buy and sell on stock exchanges. Both have a net asset value, which is the prorated worth per share of an underlying basket of securities managed by the fund company. However, CEFs often trade at discounts of 10 percent to 20 percent from NAV, while ETFs trade at their NAVs.
Reason 1: Market Forces
Prices for CEFs and ETFs ultimately stem from supply and demand for the fund shares. ETFs are usually tied to a well-known index, which creates demand for the shares by anyone interested in trading the index. CEF managers compose their portfolios as they see fit and don’t attract index traders. In addition, ETFs hire an authorized force of “price police,” and when these authorized participants see a difference between an ETF’s NAV and its share price, they immediately buy or sell ETF shares to trade away that difference. CEFs, alas, have no such help.
Reason 2: Manager Reputation
You can find some all-stars among the fellowship of CEF managers. Funds run by financial celebrities may attract more investor groupies who keep discounts low. However, most CEF managers are regular folk, some of whom may have lackluster performance records. If a CEF manager doesn’t get much respect, the fund might trade below NAV. Ironically, as Nobel laureate Eugene Fama has noted, only 3 percent of fund managers have the skill to produce net profits.
Reason 3: Portfolio Content
Investment themes tend to cycle through hot and cold periods -- value investing one year, growth investing the next. A CEF with a portfolio that is out of sync with the latest investment fad might be shunned by traders, causing discounts to grow. Homegrown CEF portfolios may contain some obscure stocks or bonds that are hard to sell. They are “illiquid.” Investors who fear illiquid securities might stay away from a CEF that owns many.
Reason 4: Expenses
CEF expense ratios are usually higher than those of ETFs. Part of the reason is that CEFs, but not ETFs, can borrow money to increase the fund’s returns and risks -- a tactic called “leverage.” CEFs must add the interest they pay on the borrowed money to their management fees, which tends to make the fees look worse. Thrifty investors might decide that CEFs are too rich for their blood.
Benefits of CEF Discounts
When you buy a CEF at a discount, you increase your yield on interest and dividend income. Yield is the annual cash payment divided by the share price -- lower share prices give higher yields and you get more return on each dollar of investment. Another way some traders benefit is to ride the discount cycles. CEFs frequently vary from small to large discounts and back again. Some savvy traders buy CEFs when discounts are at their greatest and sell when prices rebound.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.