Closed-end fund discounts and total return
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The facts about closed-end fund discounts and total return
One of the appealing attributes of closed-end funds (CEFs) is the potential to buy shares at a discount to net asset value (NAV). Various factors can cause a CEF to trade at a discount including poor fund performance or low distribution levels when compared to peers. Or, current performance may be acceptable, but the market may forecast that a fund’s future earnings or distribution potential is limited or declining, and may therefore bid share prices downward in anticipation of future bad news. Sometimes, however, there may be strong selling pressure that drives share price down without any discernible reason related to the actual fund. This can happen with any exchange-traded product. Market fear can prompt investors to sell, which will temporarily flood the market with supply. If a fund is caught up in this “herd mentality,” but its future earning potential seems solid, such a price drop may be temporary. This may be a good buying opportunity, if the fund’s strategy and performance match an investor’s long-term needs.
But often investors focus too much on the discount believing that discounts drive a large portion of CEF performance. Consequently, they attempt to purchase shares at wide discounts to their NAV with the intent of selling them when the discount narrows. This is not only a risky proposition as a fund’s discount may not narrow over the investor’s timeframe, and may in fact widen, it ignores the primary contributor to CEF returns: distributions.
CEFs are designed with the goal of providing attractive, regular distributions. While distributions would be expected to positively contribute to returns, over longer rolling historical time periods, they become an increasingly larger positive component of total return while the change in discounts ultimately becomes a detractor from total return, on a weighted contribution basis.
The chart below shows quarterly CEF returns for the past 20 years, broken down into the three components of a CEF’s total return:
- NAV return (“product performance”), and
- discount changes (labeled “market sentiment” because sentiment is a primary driver of market prices and therefore, discounts)
Note that the change in discount (“market sentiment”) is not consistently beneficial to returns: the positive effect of discount narrowing contributed to returns only 40 of the 80 quarters. Distributions, on the other hand, contributed positively to returns every quarter.
Over longer rolling time periods, the impact of discount changes on return becomes negative
Looking at the average contribution to returns over 1- , 3- and 5-year rolling time periods for the past 20 years, the impact of the change in discounts declines from +39 basis points to -12 basis points as distributions become the dominant component of total return.
Over rolling 1-year periods, discount change added 39 basis points, on average, to return.
Over rolling 3-year periods, discount change added just 8 basis points, on average, to return.
Over rolling 5-year periods, distributions are clearly the largest component of return while discount change detracted 12 basis points, on average, from return.
In summary, when evaluating CEFs, investors may do well to focus less on discounts and more on fund distributions, and the primary role distributions have played in longer term total return.
Summary of contribution data
Source: All data from Morningstar Direct, 1 Apr 1999 – 31 Mar 2019
RISKS AND DISCLOSURES
It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund’s investment objective will be achieved. Closed-end fund shares may frequently trade at a discount or premium to their net asset value (NAV).
Closed-end fund historical distribution sources include net investment income, realized gains, and return of capital. Leverage increases return volatility and magnifies a fund’s potential return whether that return is positive or negative. There is no guarantee a fund’s leveraging strategy will be successful. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time.
The material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or investment strategy and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
Nuveen Securities, LLC., member FINRA and SIPC.