closed end funds: discounts and premiums

In short

A friend of mine once bought a closed end fund because it looked like a bargain, and he could not say why the price was lower than the value of what the fund held. If you are curious about that gap, you are in good company. A closed end fund sells a fixed number of shares on an exchange, and those shares trade like any stock. The price you pay can sit above or below the value of the fund's holdings, and that gap is called a premium or a discount. Look up the fund's net asset value, called NAV, and compare it to the market price before you ever place an order. Read the fund's own reports for its fees, its borrowing, and how it pays out cash. Know that a discount is not a free gift, and a premium is not a promise. Ask what is driving the gap.

The whole of it

What it is

I once watched a neighbor try to sell a used truck. Two buyers looked at the very same truck and offered very different prices, and neither one was wrong. A closed end fund works a little like that. If you are holding shares of one, or thinking about it, you are holding a piece of a pool of investments run by a manager. The fund raised its money once, in an initial public offering, and then closed the doors. The number of shares stays fixed.

That is the big difference from an open end fund, which is what most people mean when they say mutual fund. An open end fund creates new shares when money comes in and redeems shares when money goes out, always at the NAV. A closed end fund does not do that. Its shares change hands between investors on an exchange, so supply and demand set the price. The U.S. Securities and Exchange Commission publishes investor education material on fund types, and a reader can look there for its own wording on this difference.

NAV is the value of everything the fund owns, minus what it owes, divided by the number of shares. Say a fund holds $100 million of assets, owes $0, and has 10 million shares. The NAV is $100 million divided by 10 million shares, which is $10 a share. If the shares trade at $9, the fund sits at a discount. If they trade at $11, it sits at a premium. Same fund. Different price.

How it works

You have probably noticed that a stock price moves all day long. Closed end fund shares do the same. The NAV, though, is figured from the value of the holdings, and most funds report it once a day after markets close. So the market price and the NAV can drift apart, and they do.

Why would a fund trade for less than its holdings are worth? Buyers and sellers may feel gloomy about the fund. They may worry about its fees. They may not like its payout. Or the fund may hold things that are hard to sell, and buyers want a cushion for that. Why would a fund trade above its holdings? Buyers may love the manager, or like the steady cash payments, or simply want exposure to a corner of the market that is hard to reach any other way. Feelings move prices. That is just people being people.

The size of the gap is measured as a percent. Take the market price, subtract the NAV, divide by the NAV, and multiply by 100. A negative answer is a discount. A positive answer is a premium. Easy enough.

Some funds borrow money to buy more holdings. This is called leverage, which means using borrowed money to try to boost results. It can raise gains, and it can raise losses too. A leveraged fund must pay interest on what it borrows. The borrower has to repay, whether the market is kind or not. Many closed end funds also pay out regular distributions. Part of a distribution can be a return of capital, which means the fund is handing back some of your own money rather than earnings. The fund's annual and semiannual reports to shareholders spell out where each payment came from.

The numbers, and where to find yours

Here is where a reader can do some honest checking. The fund company posts a daily NAV and a market price on its own website. The fund's shareholder reports and its filings with the SEC are on the SEC's EDGAR database, which is free. Those filings list the expense ratio, the leverage, and the makeup of the holdings.

Pay attention to a few figures. The expense ratio is the yearly cost of running the fund, shown as a percent of assets. The distribution rate is what the fund pays out each year compared with its price. The premium or discount is the gap we just talked about. Many sites also show the fund's average discount over the past year or longer, which helps you see if today's gap is ordinary or odd for that fund.

Taxes matter here too. Distributions can be taxed in different ways depending on their source. The tax form from your broker, called a 1099, shows what the fund reported. For the rules themselves, the Internal Revenue Service publishes guidance on investment income and expenses. Any dollar threshold or rate that changes year to year is set out there, such as the current figure, which the official source publishes each year, and the site fills in the verified figure with its source and date.

A worked example

My cousin Marlene has $5,000 she wants to put somewhere for a long time. She finds a closed end fund with a NAV of $20.00 a share and a market price of $18.00 a share. She wants to see how big the discount is, so she does the arithmetic with her own hands.

The price minus the NAV is $18.00 minus $20.00, which is negative $2.00. Divide negative $2.00 by the NAV of $20.00 and you get negative 0.10. Multiply by 100 and the result is negative 10 percent. The fund trades at a 10 percent discount.

Her $5,000 buys 277 shares, because 277 shares at $18.00 is $4,986, and the rest is left over. Those 277 shares sit on holdings that, by NAV, are worth 277 shares at $20.00, which is $5,540. So she is buying $5,540 of holdings for $4,986. That looks like a good deal on paper.

Now the honest part. Marlene checks the fund's average discount over the past year, and it is 11 percent. So the gap today is nothing unusual for this fund. The market has been pricing it below its NAV for a long while. A discount can narrow, which helps a holder. It can widen too, which hurts. Nobody can promise which way it goes.

Marlene also reads that the fund pays a distribution that works out to $1.50 a share each year. On 277 shares that is 277 times $1.50, which is $415.50 a year. She reads the shareholder report and sees that part of that payment is a return of capital. So not all of that $415.50 is new earnings. It matters, because handing back her own money does not make her richer. It only moves money from one pocket to the other.

Last, she looks at the fee. The expense ratio is 1.2 percent. On $4,986 that is 0.012 times $4,986, which is about $59.83 a year in costs, taken out of the fund's assets bit by bit. She writes that down too. Costs are the one thing she can see clearly.

Where it goes wrong

I have made my share of mistakes, so I say this kindly. The most common slip is to treat a discount as proof of a bargain. A fund can trade at a discount for years, and it can stay there. The low price may be telling you something about the fund's costs, its holdings, or its payout. Look for the reason before you feel good about the gap.

A second slip is to chase a high distribution rate. A big payout looks fine until you learn that some of it is your own money coming back. Read the source of the payments in the fund's reports.

A third slip is to forget leverage. Borrowing can push a fund's results up or down harder than the market moves. In a bad stretch, the cost of that borrowing keeps coming due. The fund must pay it.

A fourth is paying a premium without thinking. If a fund trades at a 12 percent premium, a buyer is paying $1.12 for every $1.00 of holdings. If the premium shrinks, the shares can fall even when the holdings do not. That is a real cost.

Last, many people trade these shares at bad moments. Trading volume can be thin, and the gap between the buying price and the selling price, called the bid ask spread, can eat into a small order. A limit order, which sets the most a buyer will pay, helps protect against that. Plain care goes a long way.

Questions to answer before you leave this page

What is the fund's NAV today, and what is its market price, and how big is the gap in percent? Is that gap larger or smaller than its average over the past year, and do I know why? What does the expense ratio cost me each year on the dollars I plan to put in? Does the fund borrow money, and how would that change things in a rough year? How much of the distribution is earnings, and how much is a return of capital, according to the fund's own report? Where does the fund's shareholder report and its SEC filing live, and have I actually read them? Is my order sized so the bid ask spread will not take a bigger bite than I expected? And have I looked at what the IRS says about how these distributions are taxed for me?