Unveiling the Potential Benefits of Closed-End Fund Discounts

One of the unique attributes of closed-end funds (“CEFs”) is the potential for their market price to differ significantly from the net asset value (“NAV”) of their underlying assets. As of 12/31/24[1], the majority of US-listed CEFs traded at a discount to NAV, creating potential opportunities for savvy investors. While this dynamic might initially deter some, understanding the nature of these discounts can reveal compelling advantages for both experienced and novice investors alike.

Understanding Discounts and Premiums

CEFs differ from open-end mutual funds in how their shares are priced and traded. Unlike mutual funds, where shares are bought and sold directly at the NAV, CEF shares are traded on stock exchanges. This allows market forces of supply and demand to determine the trading price, which can result in prices deviating from the NAV. These deviations manifest as premiums (when market price exceeds NAV) or discounts (when market price is below NAV).

The reasons behind these pricing disparities are both complex and difficult to measure, influenced by factors such as economic conditions, interest rates, fund performance, and investor sentiment about the asset class. For prospective investors, these discounts can create opportunities to acquire assets at prices lower than their intrinsic value.

The Appeal of Buying at a Discount

Investors purchasing CEFs at a discount can benefit in two key ways:

1) Additional Price Appreciation Potential: If a fund purchased at a discount sees its market price converge toward or exceed its NAV over time, the investor can realize significant capital gains. For example, if a CEF trading at a 10% discount rises to match its NAV, this would represent a direct price return in addition to any gains in the NAV itself. This dual opportunity enhances the overall return potential of the investment.

2) Enhanced Income Returns: Distributions from CEFs are often calculated based on NAV but paid out to investors based on the market price. This means buying a fund at a discount can result in a higher yield relative to the purchase price. For instance, a fund offering an 8% distribution on NAV could provide a 10% yield if purchased at a 20% discount.

A Hypothetical Example

Consider two funds, both with a NAV of $100 (Exhibit A, below). Fund A trades at a 20% discount ($80 market price), while Fund B trades at NAV. If the NAV of both funds rises by 5% to $105, Fund A’s market price rises to a 10% discount to its NAV, and Fund B maintains no discount, the investor in Fund A would realize a 19% price return, compared to just 5% for Fund B. Similarly, if both funds pay $8 per share in distributions, the yield for Fund A investors would be higher due to the lower purchase price (Exhibit B, below).

Exhibit A:
Exhibit B:

Strategic Considerations

While the benefits of discounts are clear, it is important to recognize that market movements and distributions are not guaranteed. Discounts may not narrow, and can even widen further, while distribution rates may change. Nevertheless, for investors who carefully research and select funds, these price dislocations can present a compelling opportunity to enhance returns.

Unlocking the Potential

Closed-end fund discounts offer a unique avenue to potentially increase returns and income. By understanding the mechanics of CEF pricing and leveraging discounts strategically, investors can uncover value in this often-overlooked segment of the market. For more insights on navigating the world of CEFs, visit SRHFunds.com or reach out to info@srhfunds.com to learn more.

[1] Source: Morningstar Direct.

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