Closed End Funds and the Persistence of the Discount
Why closed end funds trade below what they hold, the three mechanisms that keep the discount open, and how to tell an opportunity from a warning.
A closed end fund is a pool of investments wrapped in a company with a fixed number of shares. Unlike an open end fund, which creates and cancels shares every day at the value of what it holds, a closed end fund raised its money once, at the offering, and its shares have traded among investors ever since. That single design choice gives the fund two prices where most funds have one, and the gap between them is the subject of this note.
What a discount is and why it exists
The first price is the net asset value, which is what the portfolio inside the fund is worth. The second is the share price, which is what someone will pay you today for a claim on it. When the share price sits below the net asset value, the fund trades at a discount. When it sits above, at a premium.
The discount exists because nothing forces the two prices together. An open end fund closes the gap automatically, since anyone can hand back shares for their share of the assets. A closed end fund offers no such door. The only way out is to sell to another investor, and that investor sets the price with reference to many things besides the assets: the fees the manager charges, the leverage the fund carries, the income it pays, the difficulty of trading it, and whether anyone else wants it that day. A discount is the market’s running verdict on all of those at once.
Why it persists
Discounts appear for many reasons. They persist for three.
- The fee is a permanent claim on the assets. A fund that charges a management fee every year is, from the shareholder’s point of view, a portfolio with a leak in it. A rational buyer will pay less than asset value for a pool that is being drained, and the larger the fee relative to what the portfolio can earn, the wider the discount will settle. Nothing about a good year changes this arithmetic, which is why the discount returns after every rally.
- Nobody with the power to close it is paid to. The manager earns its fee on assets, not on the share price, and a discount does not reduce the assets. Closing the gap, whether by buying back shares, converting to an open end structure or winding the fund up, shrinks the thing the manager is paid on. The shareholders who could force the issue are usually dispersed, small and unorganized. So the one party with the means lacks the motive, and the parties with the motive lack the means.
- The buyers who would arbitrage it away cannot get out. In most markets, a persistent gap between two prices for the same thing attracts capital that closes it. Here the arbitrage requires holding the shares until the discount narrows, with no way to redeem and no date by which it must happen. The people who try often need to sell before it does. The discount persists because the trade that would eliminate it demands more patience than most people who notice it have.
When a discount is an opportunity and when it is a warning
The opportunity
A discount is worth pursuing when there is a mechanism, not just a hope, by which it closes. The fund may have a term, a date on which it will liquidate or offer to buy back shares at asset value. The board may have a policy of repurchasing shares whenever the gap widens past a stated level. An activist holder may be accumulating shares and be able to force a vote. The manager may be changing, with a different view of the gap. Or the portfolio itself may be about to throw off enough cash that the distribution alone justifies the price.
The warning
A discount is a warning when it reflects something about the assets that the asset value does not. Illiquid holdings marked by the manager rather than by a market. Leverage that would force sales in a downturn. A distribution larger than what the portfolio earns, so that the fund is handing investors their own capital back and calling it income. A manager whose fee is large and whose record is short. A discount in a fund like this is not a mispricing. It is a correct pricing of the things you have not yet found.
| A discount that narrows | A discount that persists |
|---|---|
| A fixed term, tender offer or liquidation date | An open ended life with no scheduled event |
| A board that has repurchased shares before | A board that has never acted on the gap |
| A known holder with enough shares to force a vote | A dispersed shareholder base with no organizer |
| Holdings that trade daily and are priced by the market | Holdings priced by the manager |
| A distribution covered by what the portfolio earns | A distribution that returns capital |
| A modest fee relative to what the assets can earn | A fee that consumes much of the expected return |
How I approach it
I start with the assets, not the discount. If I would not want to own the portfolio at full value, a discount to full value does not interest me.
A discount is a claim on something, and the something has to be worth having.
Only then do I turn to the gap and ask whether there is a reason it should close, who would make that happen, and how long it could take.
Then I ask what I am being paid to wait. A fund with a covered distribution pays me while the mechanism works. A fund that pays nothing asks me to carry the position on faith. The first is a position. The second is a bet on other people’s behavior.
The last thing I do is read the fund’s own history of discounts. A fund that has traded at roughly the same discount through several markets is telling me the gap is structural, and that the market priced the fee and the governance correctly long ago. A fund whose discount has recently widened for a reason I can identify and that will pass, a forced seller, a rough quarter, a change in index membership, is a different animal. The first fund is telling you what it is. The second is telling you what just happened to it, and only the second is worth paying to wait for.
