closed end funds: premiums and discounts

In short

A friend of mine once bought a fund share for $9 that held $10 worth of stocks inside it, and he could not quite believe his luck. If you are looking at a closed end fund, you will see the same odd thing sooner or later. The price on the screen is often not the value of what the fund owns. That gap is called a discount when the price is lower and a premium when it is higher. Look up the fund's net asset value, which is the per share worth of its holdings, and compare it to the market price before you act on anything. A fund sponsor's website and the fund's shareholder reports will show you both numbers. Remember too that a cheap looking fund can stay cheap for years.

The whole of it

What it is

I once watched a neighbor buy a used truck for less than the book said it was worth, and he felt clever for about a week. Then he learned why the price was low. A closed end fund works a bit like that truck lot, and the gap between price and worth deserves a closer look.

A closed end fund is a pooled investment that raises money once, in an initial offering, and then lists its shares on a stock exchange. After that, the fund does not normally sell new shares or buy back old ones each day. This is the plain difference from an open end mutual fund, which issues and redeems shares at the end of every trading day at the fund's net asset value. The SEC's investor education pages, at Investor.gov, describe closed end funds in this way.

Because the shares trade like stock, their price is set by buyers and sellers. That price can drift away from the value of the fund's holdings. Net asset value, often shortened to NAV, is the fund's assets minus its debts, divided by the number of shares. When the market price is below NAV, the shares trade at a discount. When it is above, they trade at a premium. You have probably seen a house sell for more or less than its appraisal. Same idea.

How it works

A friend of mine who sells tomatoes at a roadside stand says the price depends on who shows up that day, not on what the tomatoes cost to grow. Fund shares behave in a similar way. Nobody forces the market price to match NAV, since the fund does not stand ready to redeem shares at that value.

NAV is figured by the fund, usually once each trading day after the markets close. The share price, though, moves all day long. So the gap you see during the afternoon is only a rough guide, because the NAV you are comparing against may be a day old.

The discount or premium is a simple percent. You take the market price, subtract NAV, divide by NAV, and multiply by 100. A negative result is a discount, and a positive result is a premium.

Why do gaps form at all? Investors may like or dislike the fund's manager. They may want the income the fund pays out. They may worry about the fund's borrowing, its fees, or the market it invests in. Some funds hold assets that are hard to price or hard to sell quickly, and that can widen the gap. Sentiment matters too. The same fund can sit at a discount in a gloomy season and at a premium in a cheerful one.

Some funds use leverage, which means they borrow to hold more assets. The fund's shareholder reports describe this, and the borrowing adds both cost and risk. Funds can also pay a distribution that includes a return of capital, which means some of the payout is your own money coming back. The fund's reports must label that. So a high payout does not always mean high earnings.

The numbers, and where to find yours

If you are holding a closed end fund, or thinking about one, you need four figures. They are the market price, the NAV, the expense ratio, and the distribution history. All four come from public documents.

The fund sponsor's own website usually lists the daily NAV, the market price, and the current premium or discount. The fund's annual and semiannual shareholder reports, filed with the SEC, give the expense ratio, the holdings, and any borrowing. You can read those filings free on the SEC's EDGAR database. The fund's prospectus explains the strategy and the fees.

Where a rule sets a limit, the site will fill in the verified figure. For example, funds that use borrowing face an asset coverage requirement under the Investment Company Act of 1940, and the required coverage ratio is the current figure, which the official source publishes each year. The page will show its source and date.

Brokerage costs count as well. You pay a commission or spread when you buy or sell the shares, and your broker's fee schedule lists it. Short sentence, real money.

A worked example

Let me tell you about a retired teacher named Margaret Ellison. She was reading about a bond fund and found that it held assets worth $200,000,000 and owed $20,000,000 in debts. The fund had 10,000,000 shares outstanding.

First she found the NAV. Assets of $200,000,000 minus debts of $20,000,000 is $180,000,000. Then $180,000,000 divided by 10,000,000 shares is $18 a share. That is the NAV.

The shares traded on the exchange at $16.20. So the price was below NAV. She took $16.20 minus $18, which is negative $1.80. Then she divided negative $1.80 by $18, which is negative 0.10. Multiplied by 100, that is negative 10 percent. The fund traded at a 10 percent discount.

What did that mean for her? If she bought 100 shares, she would pay 100 times $16.20, or $1,620. The holdings behind those shares were worth 100 times $18, or $1,800. She was paying $1,620 for $1,800 of assets. A fair question, though, is whether that gap would close.

Suppose the fund's discount stayed at 10 percent and the NAV rose to $19.80. The price would then sit at $17.82, since $19.80 times 0.90 is $17.82. Her 100 shares would be worth $1,782. Now suppose the discount grew to 15 percent while NAV stayed at $18. The price would fall to $15.30, because $18 times 0.85 is $15.30, and her 100 shares would be worth $1,530. Same holdings underneath. Different price on top.

Margaret also checked the distribution. The fund paid $1.08 a share each year. At her $16.20 price, that is $1.08 divided by $16.20, or 6.67 percent of what she paid. Then she read the shareholder report and saw that part of the payout was labeled return of capital. So that 6.67 percent was not all earnings. She was glad she looked.

None of this tells Margaret what to do. It shows her what she is paying, what she is getting, and what could move.

Where it goes wrong

I have made my share of mistakes, and most of them came from hearing one nice number and stopping there. A discount is that kind of number. It looks like a bargain, yet it may not be one.

A discount can last. Nothing requires it to close. A fund can trade at a 10 percent discount for years, and the shareholder who bought for the discount may wait a long time with no payoff. A discount can also widen after you buy, as Margaret's second case showed.

A premium carries its own risk. A buyer who pays $22 for shares with a NAV of $20 pays $2 extra for each share, a 10 percent premium. If the premium fades, the price can fall even when the holdings do fine.

Leverage can hurt. When markets drop, borrowed money magnifies the loss, and the fund still owes its lenders. The borrower has to repay, whatever the market does. Fees take a bite too, and they come out of the fund every year whether it earns or not.

Beware the payout trap. A big distribution that is mostly return of capital shrinks the fund's asset base over time. The shareholder reports label this, so read the label.

Thin trading is another snag. Some closed end funds trade only a few thousand shares a day. The gap between the buying price and the selling price can be wide, and a large order can push the price. Check the average daily volume before you assume you can sell at the quoted price.

One more thing. The discount figure you see online may use a stale NAV. Check the date.

Questions to answer before you leave this page

Do you know the fund's NAV and its market price today, and have you worked out the percent gap yourself? Have you read the shareholder report to learn how much the fund borrows and what it charges each year? Can you tell how much of the distribution is earnings and how much is return of capital? If the discount grew wider after you bought, would you be able to live with the lower price? If the premium shrank, would that change how you feel about what you paid? Have you checked how many shares trade on a normal day, and what it costs you to buy and sell? And have you written down your own reason for owning the fund, so you can look at it again in a year?