Closed End Funds and NAV

Posted By: Advisor Analyzer Team

The Puzzle:

Unlike open end funds, which are continuous offerings, closed end funds are mutual funds where the number of shares offered are limited.   The main result of a limited supply of shares is the prices are dictated by the demand for the fund.  Sounds fairly intuitive at first but upon closer examination, we discover this is one of the market’s many perplexing enigmas.

 

Closed end funds, like all funds, are simply a portfolio of investments.  Simply put, owning 100 shares of such and such fund is no different than owning 6 shares of one stock and a half dozen shares of another.  The weighted average value of all these individual stocks should make up the total value of the closed end fund itself.  However, this is rarely the case, and there are fund values that trade at a significant discount to the underlying assets at times, and synergies (premiums) created in others. 

 

So why do these funds trade at a premium or discount?  Usually, it’s a combination of various factors; the portfolio manager’s popularity, the average trading activity, the overall number holdings etc.  Many very intelligent market experts are still riddled by the phenomena.  The original belief was investors would be able to profit from such mispricing (arbitrage) and the discounts or premiums would be short lived.  Investors would purchase the undervalued fund and short the underlying assets and wait for the prices to converge back to intrinsic. 

Reasons:

Why doesn’t someone buy the fund at a discount and sell A&B separately in the markets?  There are a few possible reasons that make taking advantage of the mispricing easier said than done.  First, investors are not allowed to separate the fund into their individual holdings.  Therefore, it is nearly impossible to purchase AB and subsequently sell or exchange A and B separately (i.e.  AB ≠ A + B).  Theoretically, the only way to capture the arbitrage profits is by purchasing the whole AB fund, and selling the pieces for profit.  Since this is not a feasible for the most of us, these funds stay at the mispriced levels.           

Another reason the prices do not reflect the NAV, is the uncertainty of the fund’s underlying investments.  The holdings of the fund are released to the public on a quarterly basis and the portfolio manager can dramatically shift the allocation in between reporting periods.  This creates additional problems for an investor attempting to capitalize from the mispricing.   

 

When all is said, closed end funds are a portfolio of investments that aren’t dictated by the underlying asset values.  They have the potential to be more volatile than the aggregate price fluctuations experienced by the underlying assets in the portfolio.  Investors of closed end funds must realize that avoidance of front and back end sales charges are not necessarily the best reasons to invest in closed end funds.  While not written in black and white via fees, closed end funds have its own cost demons to conquer and investors should not haphazardly adopt such positions in their portfolio.  As is always the case, the buyer should always beware.

Conclusion

As stated, closed end fund prices are completely dictated by the markets: buyers and sellers.  A peculiar consequence of limiting the number of shares available, closed end prices frequently deviate from their intrinsic value aka Net Asset Value (NAV).  As buyers outnumber sellers the fund trades at a premium; it trades at a discount in the opposite scenario.  If there were zero buyers of this fund, the price can theoretically fall to zero even when the combined value of AB equals $3.  Therefore, in addition to the risk of the underlying securities (A&B), closed end investors face additional risk from the fund itself (AB).  Basically, in exchange for the front and back end charges, investors are charged the risk of price deviation from intrinsic value.