Why Do Closed-End Funds Trade At Discounts Or Premiums To Their Net Asset Values?

The concept of a portfolio arose out of the desire to diversify investments and, in the process, minimize risk. One of the several avenues to invest in a portfolio is through a closed-end fund, or CEF.

In this educational piece, Benzinga set out to clarify for investors the rationale behind a CEF trading at a discount or premium and the implications for each.

Closed For Inflows And Outflows

A CEF is an investment company, whose shares are traded on the open market just like a stock or an ETF. As it is closed, capital does not flow into or flow out of the fund when investors buy or sell shares.

A CEF, which is usually managed by an investment management company, offers its shares to the public through an IPO and the money raised through the offering is used to buy securities.

A CEF is focused on a particular geography, industry or sector. A majority of capital gains and investment income, a CEF earns is passed onto investors in the form of cash dividends.

How Are Closed Funds Valued?

Just like a mutual fund, a CEF has a net asset value, or NAV that is calculated on a daily basis. NAV of a CEF is the value of all assets, fewer liabilities, divided by the number of outstanding shares. It reflects the value of assets held in the portfolio.

Unlike open ended funds, CEFs have a fixed number of outstanding shares and do not issue or redeem shares on a daily basis to meet investor demand.

Since CEFs trade on an exchange, the price of CEF shares fluctuate throughout the trading day, governed by the basic demand and supply equation.

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Measuring The Performance Of A CEF

The performance of a CEF is often measured by the relationship NAV has with its market price. If the market price of a CEF falls below the NAV, the fund is said to be trading at a discount. Conversely, if the market price is above the NAV, a CEF is said to be trading at a premium.

The Firsthand Technology Value Fund Inc SVVC, which has among its top holdings Pivotal Systems, IntraOp Medical, QMAT, Wrightspeed and Nutanix Inc NTNX, had a preliminary NAV of $18.74 per share, as of September 30, 2017.

However, the market price of the fund by the end of September was $8, which represents a steep 57 percent discount.

Also trading at a discount is GSV Capital Corp GSVC, which had a NAV of $9.11 as of June 30 but was priced at $5.85 at Tuesday's close. This would mean the fund is trading at a 47 percent discount.

Meanwhile, Pimco Municipal Income Fund PMF closed at $13.64 Tuesday, a 5.33 percent premium to its NAV of $12.95.

Goldman Sachs BDC Inc GSBD was trading at $22.38 on Tuesday, a 23 percent premium from the NAV of $18.23 (as of June 30).

Why a Premium/Discount?

The market price of a CEF is primarily dictated by the forces of supply and demand. Depending on the demand for the fund, it could trade at a premium or a discount. And the demand could hinge on a host of factors such as the yield of the fund relative to similarly focused CEFs, broader market sentiment, sectoral outlook, economic outlook, preference for or aversion toward levered instruments etc., according to PIMCO.

Popularity of the fund manager, the fee they charge and recent changes in the distribution policy may also result in premium or discount valuation of CEF.

A discount to the NAV may reflect a market perception that the fund's future earnings or distribution potential are at risk. Since CEFs are built based on a theme, a discount could signal that a particular industry/sector/asset class may be out of favor with investors.

However, there is a view that discounted pricing helps in pocketing dividend yields, which are significantly more than the yields on the underlying asset class.

Assuming that a CEF X has a NAV of $100 and it distributes $10 as dividend, the distribution rate is 10 percent (($10/$100)*100). If X trades at $90, a 10 percent discount, the distribution rate is 11.1 percent (($10/$90)* 100 ).

A discount also creates a value buying opportunity, which is picking undervalued asset classes trading below their intrinsic value.

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