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.
Can closed-end funds trade at a discount? ›
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.
Is a discount to NAV good? ›
If investment trust shares are trading at a discount to NAV it can give the impression that the shares are cheap because the fund isn't worth investing in. Although this isn't always the case, boards don't want investors to be put off by a discount that is too wide.
Why some close ended funds are quoted at a discount to their NAV? ›
Because fund shares trade on organized exchanges, just like the shares of corporations, the market value of the closed‐end fund shares may differ from NAV. When the market value of closed‐end fund shares exceeds NAV, the shares are said to trade at a premium. If market value is less, the shares trade at a discount.
What are the risks of a CEF? ›
CEFs frequently trade at a discount to NAV and there is no assurance a CEF will appreciate to its NAV. Interest rate Risk – Income received from a CEF may fluctuate significantly based on changes in interest rates. As interest rates rise, bond prices usually fall, and vice versa.
What is the disadvantage of closed ended funds? ›
Disadvantages of Close-Ended Funds
Premiums or Discounts to NAV: Since these funds trade based on market dynamics, they can trade at significant premiums or discounts to their NAV. This pricing can be a disadvantage if an investor needs to sell when the fund is trading at a discount.
Are CEFs good for retirement? ›
“If you are a retiree and you are counting on monthly income, CEFs may fit perfectly in your portfolio,” she says. But Marfatia also cautions that while CEFs provide exposure to a wide variety of asset classes, they often contain leverage, which means additional risk.
Why trade at discount to NAV? ›
A discount to NAV surfaces when the market trading price is lower than the most recent NAV. A discount often indicates the market is generally bearish on the investments in the fund and the fund company's potential to generate returns. The NAV of a fund is calculated after the close of each trading day.
Should I invest more when NAV is low? ›
The notion that a Mutual Fund's performance is inversely related to its NAV is a misconception. NAV is simply the per unit value of the fund and it does not reflect its quality or potential. For example, a fund with an NAV of Rs 22 is not necessarily superior or inferior to one with an NAV of Rs 85.
Why do property companies trade at a discount to NAV? ›
According to the noise theory, fluctuations in departures from NAV are caused by changes in investor sentiment. That is, when investors become (irrationally) pessimistic about REITs, the value of REIT shares is pushed below their true, underlying value.
Most are seeking solid returns on their investments through the traditional means of capital gains, price appreciation and income potential. The wide variety of closed-end funds on offer and the fact that they are all actively managed (unlike open-ended funds) make closed-end funds an investment worth considering.
What are the best closed-end funds? ›
5 Best Closed-End Funds for 2024
| Closed-End Fund | Distribution Rate* |
|---|
| Ecofin Sustainable and Social Impact Term Fund (TEAF) | 9.4% |
| Eaton Vance Tax-Advantaged Global Dividend Income Fund (ETG) | 8.4% |
| Eaton Vance Enhanced Equity Income (EOI) | 8.4% |
| Nuveen S&P 500 Buy-Write Income (BXMX) | 7.2% |
1 more rowJun 26, 2024
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.
Which is better CEF or ETF? ›
Fees — Closed-end funds typically have higher expenses and management fees than exchange-traded funds. In contrast, exchange-traded funds have a lower expense ratio than CEFs since they do not charge management fees. Transparency — CEFs are typically less transparent than ETFs.
Do CEFs have fees? ›
Most leveraged CEFs levy management fees against total assets, not just net assets, though this is not considered a best practice. Doing so results in higher management fees. A management fee of 0.50% on a $500 million unleveraged fund is $2.5 million.
How is CEF income taxed? ›
Generally, shareholders of CEFs must pay income taxes on the income and capital gains distributed to them. Each CEF will provide an IRS Form 1099 to its shareholders annually that summarizes the fund's distributions. When a shareholder sells shares of a CEF, the shareholder may realize either a taxable gain or a loss.
Do closed-end funds trade at NAV or market price? ›
Unlike open-end funds, closed-end funds (CEFs) have a fixed number of shares. This, combined with market forces, means their market price can fluctuate above or below their net asset value (NAV). High demand for fewer CEF shares leads to a premium (a price above NAV).
At which price can a close-ended fund be sold? ›
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. There are several reasons for this.
Do closed-end mutual funds trade on an exchange? ›
A common misunderstanding is that a closed-end fund (CEF) is a traditional mutual fund or an exchange-traded fund (ETF). A closed-end fund is not a traditional mutual fund that is closed to new investors. And even though CEF shares trade on an exchange, they are not exchange-traded funds (ETFs).
What are the rules for a closed-end fund? ›
A closed-end fund generally is not required to buy its shares back from investors upon request. That is, closed-end fund shares generally are not redeemable. In addition, they are allowed to hold a greater percentage of illiquid securities in their investment portfolios than mutual funds are.
