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The secret to navigating closed-end funds

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The first thing most investors ask about a closed-end fund is typically: “Is the fund trading at a discount?”

Here’s a harder question: “Why is a fund trading at that discount or premium, and is the premium/discount logical?”

The fact that closed-end funds trade at market prices different from their net asset values (NAV) creates angst and confusion, but also opportunity. Advisers need to wisely discern when there might be opportunity, and when not.

It is important to remember that most closed-end funds are designed for income or cash flow, fueled by the total return of the fund’s strategy. Before considering the price, make sure the fund is managed by a fund sponsor that shares plenty of timely information and its strategy makes sense for clients.

Also, keep in mind the basic math of the discount. Discounts represent the relationship between the market price and the NAV. A premium or discount can change while the market price doesn’t, and vice versa. A widening discount doesn’t necessarily mean the price dropped; it could be the result of an increasing NAV.

At times, there are understandable reasons for a fund’s premium price:

  • While demand is high, there could be limited attractive alternatives for a specific fund. This is more frequently seen in state-specific municipal bond funds as well as in strategies new to closed-end funds.
  • Alternatively, investors may expect future market conditions to positively affect a particular fund’s strategy. In early 2013, for example, many senior loan funds’ prices rose to persistent premiums when the market expected short-term rates to rise — an environment that would benefit floating rate senior loan funds.

In contrast, since fund share prices are typically correlated with distribution amounts, a less logical premium may occur when a fund pays high distributions that are not fully fueled by the longer-term NAV return. If the fund persistently depletes its NAV to pay its distributions, a premium price may not make sense.

Similarly, discounts also can be more, or less, logical:

  • Discounts often widen when investors have a negative forecast for a fund’s future earnings or distribution potential. When oil prices dropped in late 2014, for instance, investors eschewed funds holding securities issued by energy companies. These funds’ prices fell, discounts widened, and many experienced negative NAV returns and reduced distributions. Discounts then, probably made sense for these funds.
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  • Discounts sometimes expand in the fourth quarter as investors sell shares to realize tax losses.

  • And, there are illogical reasons for discounts:

    • Market fears resulting in widespread selling increases volatility and causes prices to drop, even though the fund’s NAV, NAV return and distribution potential may not have changed.
    • At times fund information isn’t readily available or investors don’t read it. Particularly in unique asset classes or strategies: a fund’s NAV might perform as the fund sponsor expects, but a mismatch happens when the market has different expectations or assumptions, sending prices down.
    • If a fund is caught up in herd mentality or tax-loss selling pressure, but its future earning potential seems solid, a temporary price drop or wider discount can be a good buying opportunity.

    While closed-end fund discounts have generally narrowed from an average of nearly -10% last summer (Aug. 31, 2015) to less than 5% as of July 29, 2016, we believe opportunities still exist.

    So, how can advisers assess closed-end fund opportunities, taking discounts and premiums into consideration?

    While closed-end fund discounts have generally narrowed from an average of nearly -10% last summer (Aug. 31, 2015) to less than 5% as of July 29, 2016, we believe opportunities still exist and advisers should consider the following steps:

    • As always, start with the client’s needs. What asset strategies could complement an existing income portfolio? What is the time horizon? What dollar amount would be invested?
    • Start or maintain a watch list of potential funds. A fund screener tool enables selections by strategy, market capitalization, performance, fund sponsor and more. With this tool, you can examine a fund’s NAV performance and distribution rate relative to NAV over various time periods, allowing advisers to decide whether they like its future earning and cash flow potential.
    • Monitor pricing data points. It is important to observe a fund's 52-week average discount/premium values and z-scores for 3, 6, and 12 months. A z-score is the difference, in standard deviations, between a fund’s current price and its average price over that time period. So a z-score of -2.0 means the fund’s current price is 2 standard deviations lower than its average price for that given time period.
    • When market volatility increases, prices drop, or discounts widen, be ready to capitalize on the situation. If your desired purchase represents more than 10% of a fund’s average daily trading volume, consider breaking the transaction into two or more pieces and work with your firm’s trading desk to avoid your client’s purchase substantially moving the fund’s price. Either way, strongly consider using limit orders to assure your price range.

    Closed-end funds offer attractive income and cash flow potential, portfolio diversification and the ability to invest in less liquid asset classes. Further, they offer increased flexibility and return potential since closed-end funds can stay fully invested without holding cash to meet daily share redemption requests. Discerning advisers and their clients may benefit from having patience in finicky and volatile markets that can create opportunities at attractive price points —especially for those who take the time to assess whether discounts or premiums are logical or not.

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