Closed-end mutual funds are investment companies that offer shares to the public and are publicly traded on a stock exchange. They differ from open-ended mutual funds in that they have a limited number of shares outstanding and generally do not accept new money after the initial public offering. Thus, they are capitalized once at the beginning of their life and the proceeds are used to purchase a basket of securities that the investment company will manage targeting a specific strategy. Popular strategies include foreign country funds (emerging and developed markets), targeted municipal bond funds,(state level taxable or tax-free, etc.) and diversified stock and bond strategies. NAV (net asset value) is the measure of total assets less any liabilities on the part of the investment company. This NAV number generally represents the book value or net asset value that each share of the mutual fund "owns."
Because closed-end funds are traded on a public stock exchange, the price of the shares will be determined by the market. As such, the share price at any point in time will likely trade at either a premium or discount to the stated NAV. Over the longer term, the share price and the NAV should converge. There are many times when closed-end funds will trade at a premium or discount to NAV when there is no discernible reason for the difference to exist. Normally, though, the differences will be based upon the perspective of the buyers and sellers and their expectations for the future performance of the assets. For example, if you are looking at a long term municipal bond fund and investors are expecting interest rates to decline to a level that is lower than the current level, you may see the fund trade at a premium. This signifies that investors are willing to pay more today to get the future potential appreciation.
If you have a fund that invests in private debt instruments of private companies, and interest rates are going up, you may see the fund trade at a discount to NAV as the market expects there to be write-downs in the value of the debt instruments when future financial results are released. Some funds, such as emerging market funds, may trade at a discount due to the illiquidity of the underlying shares owned by the fund, signifying that investors expect the fund to have a hard time selling these assets at the current prices in the event they were forced to sell. At the end of the day, the discount or premium to NAV boils down to an imbalance in the supply/demand dynamic for the fund and its strategy. If no one wants to own the fund, it is likely to sell at a discount to entice buyers. If everyone wants to own the fund, it will likely trade at a significant premium. Beware, that as the fund is an investment company, it has costs to run its operations, and if they are very high, they are likely to cause the shares to trade at a discount. Also, funds with a very small number of shares will likely have greater fluctuations in their premia/discounts across time. As with all investments, closed-end funds can be a great instrument, but you need to do your diligence and truly understand the finances of the fund and the outlook for the strategy that is being pursued. It is always advisable to discuss an investment in closed-end funds with your advisor before making any investment.
Supply and demand. Closed-end funds have a fixed supply. When demand for these funds rises, the assets can trade at a premium (above their net asset value). When demand falls, the funds can trade at a discount (below their net asset value). There are some closed-end funds (CEFs) that always trade at a discount. Not all CEFs that trade at a discount are a good buy opportunity.
Open-end mutual funds (and ETFs) have a flexible supply. In this case, shares are created and redeemed to match demand. Open-end mutual funds can also trade above and below NAVs - but usually just for a very short period.
There are a number of reasons why some closed end funds trade away from their (NAV) net asset value, but it primarily has to do with just a few. Due to their limited number of shares, hence the name “closed” end funds, the market forces of supply and demand come into play creating potential deviations from the actual underlying value of the fund. Demand for the fund can come in many forms including: attractiveness of the manager, asset class, peer group, etc. It’s also important to pay attention to fees which can have a significant impact on the value of the funds holdings.
Intuition tells us that a mutual fund's net asset value (NAV) (the net value of all assets within the mutual fund's portfolio divided by the number of outstanding shares) should be identical to its market price, but often, the market price of a closed-end mutual fund (a fund with a fixed number of issued shares that can't be altered) will trade either above or below its NAV. When this situation occurs and the fund is trading above this price, it is said to be trading at a premium; conversely, when the fund is trading below this price, it is said to be trading at a discount.
Here are some possible reasons for why these funds trade at premiums or discounts:
and - the fundamentals of supply and demand will adjust the trading price of a mutual fund compared to its NAV. If the fund is in high demand and low supply, the market price will typically exceed the NAV. If there is low demand and much supply, the market price will usually be lower than the NAV.
- Another reason why there may be a price deviation between the NAV and market price is the management team responsible for the fund itself. Sometimes, if the manager is highly regarded, a premium will be paid by investors wishing to hold the fund. If the management is not as highly regarded, the fund may trade at a discount.
Expectation - Similar to a stock, the expectation that a mutual fund's will perform well may affect whether the market price is above or below the NAV. Portfolios with expected to perform well in the near future will demand a premium to NAV, while those with assets expected to perform poorly may sell at a discount.
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Unlike the open-end mutual funds, close end funds only offer a certain amount of shares. Thus, its trading is driven by supply and demand. When an overwhelming amount of investors want certain close-end funds, it will drive up the price of the fund. That’s when you see the price above the NAV. On the other hand, once the demand for the fund cools down, that’s where you see the bargain price, namely the discount value. So, take your time to study the fund and patiently wait for the opportunity should you want to own the close-end funds. Best!