2023-11-19 08:21:24 ET
Summary
- Everybody loves a bargain, including investors who can buy closed-end funds at discounts.
- A big advantage of discounts is that you have more assets working for you than you had to pay for.
- That means your investments earn a higher yield than they would have if you'd had to pay full price.
- Normally higher yields mean higher risks, but not in this case.
Mutual Funds: Closed-End and Open-End
One of the interesting features of the closed-end fund market is that the funds are traded on stock exchanges rather than being bought from, or sold directly to, the fund sponsor, which means the price we pay or receive when we buy or sell a fund may be above or below the fund's actual "Net Asset Value." This means that closed-end fund shares sometimes sell at discounts from their net asset values, while at other times they may sell for more than their actual net asset value (i.e. at a "premium").
This is quite different from a traditional "open-end" mutual fund, where investors buy shares directly from the fund sponsor, at a price that is set daily by dividing the total assets of the fund by the number of outstanding shares. That value, per share, is called the "Net Asset Value" or "NAV," of the fund. Investors who want to cash out their shares can redeem them directly from the fund company, for that same price.
The advantage of an open-end mutual fund is that investors know at the end of every day exactly what their shares are worth; and that they can collect that amount any time they want to, directly from the fund manager. But this liquidity comes at a price:
- Open-end fund managers have to keep a certain amount of assets in cash, since they never know how many shareholders will decide to redeem their shares at the end of a particular day. Keeping 5-10% or whatever they deem prudent in cash can drag down performance by reducing the amount they have available to invest in more productive and/or higher yielding assets.
- Open-end funds are not the best vehicles for investing in more complex or less liquid asset classes, like high-yield bonds, senior corporate loans, collateralized loan obligations, privately placed securities, and other "alternative" investments of the sort hedge funds and other institutional investors often like to hold; usually because these asset classes have higher yields and potential returns (albeit with less liquidity and possibly greater risks).
We've seen the dangers of open-end funds holding assets that turned out to be too illiquid to dispose of easily during volatile market periods, where the funds experience a "run on the fund" that requires them to liquidate (or try to liquidate) their assets at fire-sale prices. The best-known collapse of an open-end mutual fund in recent times was Third Avenue's Focused Credit Fund, whose portfolio was packed with "distressed" and other extremely risky corporate debt that it couldn't liquidate quickly enough to handle the wave of redemptions it suffered in 2015.
Most market observers believe that if Third Avenue Focused Credit Fund had been set up as a closed-end fund, it would likely still be in business. That's because closed-end funds have fundamental differences that make them more appropriate investment vehicles for asset classes that are, by nature, more illiquid and volatile.
Closed-End Funds (Think "Investment Company")
Closed-end funds are a type of mutual fund, in that, like all mutual funds, they are "commingled vehicles" (i.e. lots of investors' money mixed together, with each owning its own "pro rata" share of the whole portfolio). But at the same time, closed-end funds are somewhat like "investment companies" in that (1) they raise their money from their original investors via stock offerings, like a corporation, and (2) after the initial fundraising, investors in the fund who want to take their money out have to sell their existing shares on the open market, and new investors who want to invest in the fund have to buy shares from existing shareholders, just like a typical public company.
Unlike open-end mutual funds, closed-end funds are not required to redeem their shares at the fund's Net Asset Value (or at any other price for that matter). In other words, regardless of the fund's NAV, it is the market that determines the price at which fund shares change hands between new fund buyers and existing holders who sell their shares.
A closed-end fund's share price can go up or down throughout the trading day, just like the stock of other companies, and it need not correspond to the underlying Net Asset Value of the shares. Just as shares of many industrial or other companies are sometimes described as "undervalued" or "overvalued," a closed-end fund's shares can be under- or over-valued as well.
When the fund's shares sell at a price higher than the NAV per share it is said to be selling at a "premium." When it is selling at a price higher than its NAV, it is said to be at a "discount."
One common strategy of many closed-end fund investors is to wait and buy funds they are interested in when they are selling at a discount; i.e. essentially "on sale" or at a bargain price. That makes total sense. Who doesn't like a bargain, so buying a closed-end fund at a 5, 10 or 15% discount, other things being equal, will be attractive to many investors.
Obviously "other things" are seldom equal, so there may be reasons why some funds sell at discounts (poor performance, excessive fees, assets that are inherently risky or hard to value, etc.). But short of that, many funds end up selling at discounts merely because closed-end funds can be illiquid and quirky, with prices moving around for reasons that have no particular relationship with the actual value of the fund.
Similarly with funds selling at premiums. Some funds end up selling for more than their share's Net Asset Values, again for a variety of reasons (abnormally high distribution yields, above average long-term performance records, good marketing and public relations by fund sponsors and managers, etc.)
Closed-End Fund "Discount Strategies"
Closed-end fund investors often view fund discounts from two different perspectives. Many see discounts as an opportunity to buy in at a low price, below the inherent worth of the pool of fund assets their shares represent (i.e. below what their pro rata portion of the fund would be worth if valued separately). They would then typically anticipate a capital gain at some point (hopefully sooner rather than later), when the fund's share price eventually rises to a level more consistent with the value of the underlying assets per share.
That makes a lot of sense, especially if they research the fund's history to see what it's typical discount or premium has been throughout its history, so they can judge whether the current discount represents an outlier or not, and therefore what the odds are of making a profit when it pops back up to its more normal level.
As an Income Factory® type of investor, who is happy to rely on my cash distributions for virtually all of my total return, I view discounts in a somewhat different way. Of course, I won't ever complain if I get to buy a fund at a discounted price and then it rises so I can sell it later at a profit.
But I find discounts equally interesting and attractive if they continue indefinitely, giving me essentially a permanent "sale price" on reinvesting and compounding that particular fund.
Even beyond the bargain price for future investments, what I really like is the "bonus yield" that I derive from having more assets working for me than I actually had to pay for. Another way to look at this is that I am getting a higher yield than I "deserve," given the amount of risk I'm taking (or actually not taking ).
Please let me explain. Suppose a closed-end fund has $100 million of assets that earn a yield of 10%, i.e. $10 million of income. If we can buy that fund at a 10% discount, then the fund is still collecting and paying out its $10 million of income, but the owners of the fund have only had to pay $90 million to buy their shares. So the fund owners are actually collecting a yield of 10/90, or 11.1%, on the money they have invested.
Now typically an investor would have to take more risk to earn a yield of 11% than they would to earn a yield of 10%. Assets that pay yields of 11% are generally riskier assets (e.g. lower credit ratings, more volatile industries, greater leverage, etc.) than assets that pay 10%; and assets that pay 10% are riskier than those that pay 9%, or 8%, etc.
In our example, the fund is invested in 10% yielding assets, in terms of the risk they carry. But because we've been able to buy more of them for each dollar we invest, because of the discounted price, we are actually being paid, on our reduced level of capital, a yield of over 11%; even though we're not taking the risk that "real" 11%-yielding assets would represent.
If I'm a long-term income investor, with a goal of continually increasing my cash income by reinvesting and compounding my distributions, I'm happy if the discount never closes, so I can continue to buy additional earning assets at bargain prices. That way I continue to earn a higher yield on my newly invested funds than the "natural yield" on those assets would be if I were paying full price for them.
This difference between the yield I receive on the discounted market price I pay, and the "natural" yield on the full, un-discounted value (i.e. the Net Asset Value of the fund), can be substantial. I call it the "bonus yield" since it represents the additional yield investors receive for taking no additional risk, merely because they are able to buy the fund at a discount.
For a long-term investor, that extra 1% or more in yield, for no additional risk, makes a big difference. Under the "rule of 72" an investment's income stream doubles every X years, where "X" equals the number of times its yield divides into the number 72. So at an 8% yield a portfolio's income doubles every 9 years; at a 9% yield its income doubles every 8 years, etc. At that rate, a 9% yielding portfolio's income is 32 times its original amount after 40 years. At an 8% yield, just 1% per year lower, it takes 45 years before it's 32 times its original amount. At a differential of 1.5%, for example, the earnings growth would be even faster. This is one of the less appreciated, but very real advantages, of being able to buy closed-end funds at discounts from their actual Net Asset Value.
Here is a representative sample of closed-end funds with price discounts of various amounts. In the far right column is the "bonus yield" an investor currently owns as a result of the price discount and the resulting difference between the higher yield the fund earns on its market price (i.e. what we pay to buy it) and the lower (and less risky) yield the fund actually earns on its asset's Net Asset Value.
Note, for example, Central Securities ( CET ), with its big discount of over 19%. It's assets' "natural" yield is a somewhat sedate 7.4%; but since we get to buy them at a 19% haircut, the yield we actually collect is 9.2%, a payout that normally would require us to take substantial additional risk compared to a 7.4% yield. This is just a sample of the many closed-end funds that sell at discounts and offer investors the advantage of higher yields than the actual yields the underlying assets would pay if bought at full price.
For further details see:
How Closed-End Funds' Discounts Reduce My Long-Term Risk