Tuesday, February 2, 2010

Thoughts On Why Closed-End Funds Often Trade At NAV Discounts

Closed-end funds have investment advisers who can change the holdings of the fund consistent with the investment strategy.

Closed-end funds do not regularly redeem shares. Redemption occurs at the termination date of the fund.

Closed-end funds, because they need not worry about redemption, can buy infrequently traded shares. When a readily available market price is unavailable, funds employ a pricing methodology.

Closed-end funds pay a dividend, sometimes in excess of the dividends received from the fund's investments. The shortfall comes from the investment capital of the fund.

Buying a share in a closed end fund is buying the right to the fund's termination value (not to its NAV, Net Asset Value) and the dividend payouts of the funds. The value of these rights can deviate from NAV without violating efficient markets.

Suppose a fund is holding $1000 and has 10 shares. Each share's NAV is $100. If the fund will terminate in one year and does not invest in anything other than cash, the fund will trade at a discount to that $100 per share. The fund is giving up an investment opportunity, which let us say is 10 percent. A $1000 payment made one year from now is worth (discounted value) about $909.09 today. Its efficient market price is to trade at a 9.09 percent NAV discount.

If the fund buys illiquid and infrequently traded securities, then the premium or discount to the NAV can reflect a disagreement between the market price and the methodology used to value the underlying investments. During the financial crisis, financial institutions discounted anticipated cash flows and valued CDOs at $X. The market placed a lower value on the CDOs because it anticipated a higher default rate. The market and the financial institutions used different estimates of future payments to derive values, resulting in different valuations of the same CDOs.

If the investment adviser creates uncertainty about the fund's future investments, the increased risk above the riskiness of the current holdings can result in a discounted market price to NAV.

Additionally, closed-end funds can borrow and there is increased leverage and loan default risk to consider. There are also tax effects since closed-end funds do not pay taxes and shareholders pay the taxes on the investments, which can have a positive or negative value and can cause funds to trade at premiums or discounts.
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