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.
