Why Do Some Closed-End Funds Trade Above or Below Their Net Asset Values? (2024)

In recent years, the annual median discounts for closed-end mutual funds (CEFs) have often widened significantly. Yet, intuition would lead us to believe that a mutual fund's net asset value (NAV), the net value of its portfolio divided by the number of outstanding shares, should be about equal to its market price.

"Because closed-end funds trade on a public exchange, the price of the units will be determined by the market," said Jamie Ebersole, a certified financial planner at Ebersole Financial in Wellesley Hills, Massachusetts. "As such, at any point, the price may trade at either a premium or discount to the stated NAV. Over the longer term, the share price and the NAV should converge."

However, this doesn't, in fact, often happen, with more than 80% of CEFs in recent years trading at a discount to their NAV. When the fund is trading above its NAV, it's said to be trading at a premium; conversely, when it is trading below this price, it is said to be selling at a discount. In recent years, the annual median discounts for CEFs have widened significantly. This should offer investors significant savings, but does it? Why is this happening? Below, we explore what CEFs are and explain why their NAVs often trade at a discount.

What Is a Closed-End Fund?

CEFs pool investors' capital to create a professionally managed portfolio of securities. They issue a fixed number of shares through an initial public offering (IPO) on a stock exchange or to trade over the counter. CEFs are one of four main categories of pooled investments, alongside mutual funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).

CEFs are managed by investment professionals who invest in the fund's assets according to its objectives. There are four main types:

• Traditional CEFs: The most common are those traded on exchanges with a fixed number of shares. They hold equities or bonds, most typically, and in most years, bond CEFs hold about two-thirds of traditional CEF assets.
• Interval funds: These funds buy back a portion of their shares from shareholders at a price based on the fund's NAV. The intervals are usually three, six, or 12 months, as listed in the fund's prospectus. Unlike traditional CEFs, they don't typically trade on exchanges.
• Tender offer funds: Like interval funds but there's no set schedule for their discretionary repurchases of shares.
• Business development companies (BDCs): These CEFs focus on investing in small and medium-sized businesses.

In recent years, nontraditional CEFs have flourished, especially BDCs, which now have more total assets than equity or bond CEFs.

Advantages of CEFs Over Open-End Funds

Unlike open-end fund managers who must constantly buy and sell assets to accommodate new investments and redemptions, CEF managers can stay with their original investment strategy. This is particularly beneficial during market downturns. When markets fall, open-end fund investors often panic and sell, forcing managers to sell assets at low prices to meet redemptions. This can prevent managers from taking advantage of buying prospects created by the market decline.

There's also a tax advantage to CEFs. In an open-end fund, even investors who hold onto their shares during a market decline might face capital gains taxes if the fund sells assets at a profit to meet redemptions. In contrast, CEF investors who don't sell their shares during a downturn won't incur any tax liability, as the fund isn't forced to sell assets to meet redemption requests.

How Is the NAV Calculated for a Closed-End Fund?

The NAV is a crucial metric for all funds, including CEFs, and is the per-share value of the fund's underlying assets minus its liabilities. It's calculated using the following formula:

• NAV= (Total Assets - Liabilities) / Total number of shares outstanding.

For CEFs, NAV is an important baseline measure, but unlike open-end mutual funds, CEFs do not continuously issue and redeem shares at NAV. Instead, CEFs trade on secondary markets where supply and demand can cause the market price to deviate from NAV.

About 95% of CEFs calculate their NAV daily, while others calculate it weekly or on another schedule. This allows investors to regularly assess the fund's underlying value. However, as noted, a CEF's market price can differ significantly from its NAV. CEFs can trade at a premium (above NAV) or discount (below NAV) in the market, a key characteristic distinguishing them from open-end mutual funds.

The difference between a CEF's market price and its NAV is expressed as a percentage. For example, if a CEF has an NAV of $10 per share but trades at $9, it's trading at a 10% discount. While NAV is an important metric, it's not the sole indicator of a CEF's performance. A CEF's total return, which includes price appreciation, depreciation, and distributions, is typically a more comprehensive performance measure.

Premiums vs. Discounts

CEFs trade at a premium or discount to their NAV depending on the relationship between its market price and the underlying value of their holdings:

Premium: A CEF is said to trade at a premium when its market price per share is higher than its NAV per share. This indicates that investors are willing to pay more than the net value of the fund's assets. Reasons could include high yields, strong historical performance, or positive sentiment toward the underlying assets.

Discount: Conversely, a CEF trades at a discount when its market price per share is lower than its NAV per share. This suggests that investors can buy the fund for less than the collective value of its holdings. Reasons could include a decline in the value of the underlying assets, lower-than-expected distributions, or broader market pessimism.

For example, suppose a CEF has a NAV of $10 per share. If the market price is $12 per share, the CEF is trading at a 20% premium (12 / 10 - 1 = 0.2).

Suppose the CEF's market price falls to $8 per share; it's trading at a 20% discount (8 / 10 - 1 = -0.2). This discount could be a buying opportunity for those who believe the underlying assets are undervalued.

The Closed-End Fund Puzzle

For decades, researchers and practitioners looking to profit from buying up shares at a discount have looked to solve what's called the "closed-end fund puzzle." The puzzle refers to the oft-repeated empirical observation that CEF shares frequently trade at prices that differ from their NAV, typically at a discount. For example, in 2023, CEFs traded at a net 9.9% discount, which was wider than the 7.9% discount for all CEFs the year before. In the 1970s, discounts could reach 30% a year, with 10% to 20% more normal in the 1980s.

Basic financial theory dictates that these discounts shouldn't exist for long: like items on sale at the grocery store, they should get bought up, raising demand until the discount disappears. At the least, one would expect investors to swoop in for the arbitrage opportunity, buying at a discount and reselling later. In general, though, that doesn't happen—more buyers don't flood in to buy up the finite shares of CEFs to bring, say, the almost 10% discount in 2023 far closer to the NAV. Yet, every day, we can watch shoppers pick up discounted items over their full-priced cousins at the supermarket. Why?

Behavioral economists have long been interested in the puzzle since it seems to counter the efficient market hypothesis, which would dictate that, as we see in other markets, NAV and market prices should be relatively in sync. The CEF puzzle thus challenges the idea that two assets offering claims to the same risk-return profile should trade at the same price.

As noted in major academic papers in the 1970s through the 2000s, there tends to be a typical life cycle pattern to CEFs:

1. Initial premium: CEFs typically start trading at a premium to their NAV. This initial premium is usually around 10% and primarily reflects the underwriting and startup of the fund.
2. Transition to discount: Despite starting at a premium, CEFs typically move to trading at a discount to their NAV within 120 days of their IPO.
3. Persistent, if fluctuating, discounts: Once established, discounts on CEFs tend to persist over time, but they can also vary widely. On average, discounts in the 1980s to early 2000s ranged from 10-20% of NAV but can vary significantly for individual funds and over time. This part of the life cycle is at the heart of the CEF puzzle.
4. Discount disappears as fund ends: When a CEF announces it will liquidate or convert to an open-end fund, its share price typically rises, and the discount shrinks or disappears entirely.

Whatever the answer to the CEF puzzle, traditionally, these discounts have made CEFs attractive. They offer mutual fund investors a chance to buy shares of a professionally managed, diversified fund at a discounted price.

Let's now take up the reasons generally given for how CEFs are priced.

The primary explanation for the difference between a CEF's market price and its NAV is rooted in basic economic principles of supply and demand. Unlike open-end mutual funds, CEFs have a fixed number of shares outstanding after their IPO. This fixed supply means that the price of CEF shares in the secondary market (on exchanges) is determined by investor demand rather than by the underlying value of the fund's assets.

Supply and Demand

Key points made for this explanation include the following:

1. Price discovery: The interaction of this fixed supply with fluctuating demand leads to price discovery in the market, which may not always align with the fund's NAV.
2. Tendency to "mean reversion": This is a statistical way of saying that investors will push the NAV back toward its price over time.

"Normally, the differences [between the NAV and CEF market price] will be based on the perspective of the buyers and sellers and their expectations for the future performance of the assets," Ebersole said. However, he suggested there were limits to the macroeconomic claim that market dynamics set prices. "There are many times when closed-end funds trade above or below NAV when there is no discernible reason for the difference to exist," he said.

Management Performance and Reputation

Another reason often given for the price differences between NAV and market prices is the management team responsible for the fund itself. If a manager is highly regarded, a premium might be paid by investors wishing to hold the fund. If not, then the opposite should be expected.

This explanation is closely related to the "agency problem" often studied by financial experts. Key aspects of the former include the following:

1. Management skill: Investors may be willing to pay a premium or demand a discount based on their perception of the fund manager's ability to generate returns above or below the fund's benchmark.
2. Track record: A fund's historical performance can significantly influence investor sentiment. Consistently outperforming funds may trade at a premium, while underperforming funds may trade at a discount.
3. Reputation: The reputation of the management firm and individual fund managers can impact the fund's price. Well-known, respected managers might command a premium.
4. Future expectations: Investors may price in their expectations of future management performance, which may differ from past performance.
5. Management fees: High management fees might lead to discounts if investors believe the fund's performance doesn't justify the cost.

Here are the parts of management's supposed role in the price of CEFs related to the "agency problem"—that is, the difference between the interests of management and those of investors:

1. Agency costs: This refers to the potential conflict of interest between fund managers (agents) and shareholders (principals). Concerns about managers prioritizing their own interests over those of shareholders can lead to discounts.
2. Information asymmetry: Fund managers typically have more information about the fund's holdings and strategy than outside investors, leading to price differences.

As with supply and demand, while management performance and reputation can account for some variation in CEF premiums and discounts, it can't fully explain all aspects of the CEF puzzle, such as why discounts tend to be more common and persistent than premiums. As a result, we'll have to continue looking at other explanations.

Investor Sentiment

The investor sentiment explanation offers a behavioral finance perspective on the CEF puzzle. This theory suggests that the changing sentiment of individual investors essentially drives the discrepancy between a fund's market price and its NAV.

Positive sentiment among investors can drive CEFs to trade at premiums to NAV. Investors are more likely to be attracted to a particular asset class or investment strategy represented by a CEF during specific periods, particularly during stretches of optimism. This increases demand, given the optimism about the fund's underlying assets and potential returns, which drives the market price of the CEF above its NAV, resulting in a premium.

Meanwhile, negative sentiment leads to discounts. The explanation is that investor caution or pessimism toward the fund's performance brings about a CEF price drop.

Key aspects of this explanation include the following:

1. Sentiment-driven pricing: Most obviously, a significant element of this theory for how CEFs are priced is that individual investor optimism or pessimism changes can drive discounts or premiums.
2. Noise trader risk: The unpredictability of individual investor sentiment creates an additional risk of holding CEFs, which explains why they typically trade at a discount.
3. Correlation with small stocks: Because individual investors also disproportionately hold small-cap stocks, changes in CEFs are correlated with small stock returns.
4. When new funds appear: New CEFs tend to be issued when investor sentiment is positive and existing funds trade at premiums or small discounts.
5. Discount fluctuations: The theory explains why discounts tend to fluctuate over time and why they tend to move together across different funds. That's because sentiment also varies greatly.
6. IPO premium: Initial enthusiasm among individual investors can explain why CEFs often start trading at a premium.
7. Discount elimination: When a fund announces liquidation or conversion to an open-end structure, the discount disappears because sentiment no longer matters.

This theory gained significant traction in explaining the CEF puzzle in the 1990s, leading to speculation by some that the CEF puzzle is an example of how behavioral finance can help predict asset prices. However, it's worth noting that this hypothesis is not universally accepted, and debate continues about the relative importance of behavioral factors in determining CEF prices.

Expectations, Distribution Rates, and Yields

Other important factors influencing the pricing of CEFs relative to their NAV are investor expectations about distribution rates and yields. While this factor can help explain some variations in CEF prices, it's typically considered alongside the others since it can't account for the CEF puzzle alone.

This explanation focuses on how anticipated income from the fund affects its market price. Key aspects include the following:

1. Distribution policy: CEFs often have a preset distribution schedule, which can consist of regular dividends, capital gains distributions, or return of capital. The attractiveness of this policy can influence the fund's price.
2. Yield expectations: Investors may be willing to pay a premium for funds expected to provide high yields, especially in low-interest-rate environments.
3. Distribution rate vs. NAV yield: The fund's distribution rate (distributions divided by market price) may differ from its NAV yield (distributions divided by NAV). This difference can contribute to premiums or discounts.
4. Distribution sustainability: Investor perceptions about the sustainability of a fund's distribution policy can significantly impact its pricing. Funds with distributions viewed as unsustainable may trade at larger discounts.
5. Return of capital: Some funds may include the return of capital in their distributions. While this can provide tax advantages, it may also lead to discounts if investors think it's eroding the fund's asset base.
6. Interest rate environment: CEFs offering attractive yields may trade at smaller discounts or even premiums in low-interest-rate environments. About two-thirds of traditional CEFs are for bonds.
7. Sector-specific factors: Yield expectations can vary by fund sector. For example, municipal bond funds might be valued differently than equity funds because of tax considerations and yield expectations.
8. Distribution frequency: Funds that distribute income more frequently (e.g., monthly vs. quarterly) may be more attractive to certain investors, potentially affecting the fund's pricing.
9. Historical performance: A fund's track record of meeting or exceeding its distribution targets can influence investor expectations and, consequently, its price.

This explanation suggests that investors are not just focused on the underlying asset value of the fund but also the expected stream of distributions. Funds expected to provide attractive, sustainable yields relative to other available investments may trade at smaller discounts or even premiums. In comparison, those with less attractive or uncertain distribution prospects may trade at more significant discounts.

Underlying Asset Performance

The performance of the assets held by a CEF is another element of how it's priced. When the underlying assets increase in price, the overall value of the CEF should increase. Meanwhile, a decline in asset prices should lead to a fall in the NAV.

Market Conditions

Market conditions such as economic growth, interest rates, and inflation influence the demand for CEFs. Discrepancies between the market price and NAV can result from these changes. For instance, during periods of economic growth, investors may become more optimistic about the prospects of a particular asset class or sector, driving up the demand for CEFs that invest in those areas. During economic downturns, investors are generally risk-averse, and there's a decrease in demand and potentially lower market prices relative to NAV.

In addition, changes in interest rates and inflation can also impact the price of CEFs given their effects on overall demand in the market.

Implications for Investors

The differences between CEF market prices and their NAVs present both opportunities and risks for investors. Understanding these implications is crucial for developing well-defined investment strategies. A diversification strategy involving a basket of CEFs trading at discounts can help spread risk and help you benefit when there are narrowing discounts over time.

You should take the time to analyze the reasons behind premiums or discounts, such as fund management quality, investment strategy, and market conditions. Here are the suggested strategies in different scenarios:

The Bottom Line

The market prices of CEFs often deviate from their NAVs because of investor sentiment, fund performance, distribution levels, market conditions, and fund-specific characteristics such as investment strategy and management quality. These elements collectively contribute to CEFs trading at premiums or discounts to their underlying NAV.

While discounts may present buying opportunities, investors should carefully analyze the reasons behind a premium or discount, as well as the fund's long-term prospects. Ultimately, the sustainability of distributions and the fund's overall performance should be the primary considerations for CEF investors. These measures provide a more comprehensive view of the fund's value and potential for long-term success.