What You Need to Know About Closed-End Funds

Closed-end funds or CEFs (also called closed-end investment management companies) have become popular among income investors for their large and reliable distributions. Many CEFs are primarily focused on producing income and generate big distributions by holding income investments like dividend stocks, REITs or municipal or corporate bonds. Others boast their payouts through the use of leverage.

But there are a few unique aspects to CEFs that every investor should be aware of before adding this type of fund to their portfolio.

First, CEFs are different from mutual funds and ETFs because they issue a limited number of shares. When a new investor buys into a CEF, they have to buy from someone else who is selling their shares, like with a stock. ETFs and mutual funds, by contrast, regularly issue new shares and buy back old ones (through bank intermediaries).

This distinction is why these funds are called “closed-end.” Mutual funds, by contrast, are sometimes called “open-ended,” because they can get bigger.

In addition to the number of shares it issues, the amount of assets held by a CEF is also fixed. The CEF isn’t getting new infusions of capital, so it can’t go out and buy more of the assets it holds. That’s why a CEF’s net asset value, or NAV, is important.

The net asset value (NAV) is calculated by dividing the total value of the fund’s assets, minus its liabilities, by the number of shares outstanding. So:

NAV = (assets – liabilities) / shares outstanding

The assets are whatever kind of investment the CEF holds in its portfolio, whether stocks, bonds or something else. For leveraged CEFs, the leverage makes up most of the liabilities.

NAV is calculated the same way for any type of fund. But it means very different things to closed-end fund investors and mutual fund investors.

As you may know, mutual funds are priced based on their NAV: at the end of the trading day, a mutual fund’s price is determined by dividing the value of its assets by the number of shares outstanding. When you sell a mutual fund, you won’t know your sale price until the close of the trading day.

The price of a CEF, by contrast, is determined by the market during trading hours. That means you can buy or sell them at any time during the day, like an ETF or stock. That’s convenient.

But it also has an important implication.

It means that CEFs usually aren’t trading right at their net asset value. Most of the time, CEFs are trading slightly above or below their NAV.

The gap between the current share price and the NAV is referred to as the CEF’s “discount” or “premium.”

If a CEF is currently trading at $19.00, but its NAV is $20.00, then the CEF’s discount is -5.0%.

You can find out a CEF’s discount or premium with this equation:

(Share price ÷ NAV) – 1

Here’s one more example:

Share price = $12.00 NAV = $10.00 Premium = ($12.00 ÷ $10.00) – 1 = 1.20 – 1 = +0.20 = +20.0%

You can also look up a CEF’s current discount or premium on the fund manager’s website, or on Morningstar. Usually, premiums are denoted with a plus sign, as above, and discounts with a minus sign.

The fact that discounts and premiums exist gives CEF investors one more piece of information when considering their investment.

However, being successful isn’t as simple as buying any CEF that’s trading at a discount. Some investors think so, and will argue that by buying at, say, a 10% discount, they’re “getting $1 worth of assets for 90 cents.” But that’s an oversimplification.

For one thing, you can’t assume that a CEF’s price will always return to its NAV. CEFs can trade at a discount or premium to their NAV for years!

Secondly, there may be a reason a particular CEF is trading at a discount to its NAV. It may have made negative changes in its distribution policy, or may own assets that are out of favor.


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Third, and most important: a CEF’s NAV is not fixed. The NAV can change just as easily as the fund’s price. If you buy a CEF at a 10% discount to its NAV, but then the value of the fund’s assets declines by 10%, the discount will have been erased, but you won’t have made any money. (In fact, you’ll probably lose money as investors sell and drive the price lower.)

So while it’s important to check a CEF’s discount or premium prior to purchasing it, a big discount is not in itself a reason to buy the fund.

That being said, it is important to be careful of buying shares at too high a premium. While shares currently trading at a premium can certainly stay at a premium for a long time, their upside may be limited. Unless the NAV increses commensurately, any increase in the share price will also widen the premium gap, which may limit how far the share price can rise.

MorningStar suggests staying away from CEFs trading at a premium of over 10%, adding that “unwittingly purchasing shares at an absolute premium, only to see the share price decline as the premium narrows, is the number one reason people have a poor experience with CEF investing.”

There is one way to look at discounts and premiums that can give you a bit more information to work with.

This strategy is to compare a CEF’s current discount or premium to its average historic discount or premium. The resulting number is sometimes called the “Relative Discount” or “Relative Premium.” MorningStar argues that CEFs are more likely to return to their average discount or premium than to their NAV. They explain on their website:

“To measure relative discounts, we use a z-score:

z = (current discount – average discount) / standard deviation of the discount

“A negative z-score indicates that the current discount is lower than its average. A positive z-score indicates that the current premium is higher than average. In our opinion, a z-score of less than -2 signals that a fund is relatively inexpensive, and a z-score greater than +2 signals that a fund is relatively expensive.”

In regular English, it means that if a CEF has usually traded at a 5% discount for a few years, but is now trading at a 10% or 12% discount, it’s a possible bargain and is worth investigating.

Some of our Dick Davis Digest contributors also used relative discounts and premiums to time their CEF purchases. It’s a bit like determining a stock’s undervalue or overvalue percentage by comparing its current P/E to its average historical P/E, a common strategy among value investors.

So, the important things to remember when investing in closed-end funds are:

• Check the discount or premium of any CEF you are considering buying.

• Premiums add risk to a CEF investment because unless the NAV rises to meet your purchase price, you will likely lose money on your investment in the long run. Avoid premiums above 10%.

• While buying a CEF at a discount can increase your chances of making money, always check to see if there is a reason why they fund is trading at a discount, and remember that the NAV can also decline.

• A fund’s relative discount is more important than its discount to the current NAV, because CEFs are more likely to return to their average historical discount than to their NAV.

Bottom line: discounts and premiums are important tools to use when investing in CEFs, but don’t assume that buying at a discount means you will make money. The price you buy at and the price the CEF is trading at when you sell will determine your gain.

Wishing you success in your investing and beyond,

Chloe Lutts Jensen

Editor of Investment of the Week


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