One of the great unanswered questions in the field of investments is why closed-end mutual funds can trade at a persistent discount to their net asset value. This is the famous “closed-end fund puzzle” — what Burton Malkiel of Random Walk fame once called “one of the most enduring conundrums in the field of finance.” What are we talking about?
Well, first of all, a closed-end mutual fund is different from a regular open-end mutual fund. An open-end fund always sells and redeems shares at net asset value. That means that a share of an open-end fund always equals the market value of its components (though there may be a sales charge or redemption fee).
But a closed-end fund issues shares only once. The number of shares remains fixed and the shares trade on a stock exchange just like an ordinary stock, with their value fluctuating according to buying and selling activity. That means closed-end fund shares can trade at a premium or discount to their net asset value.
Historically, closed-end funds have, on average, traded at a discount. The chart here shows this discount – and how it has changed over time. And if you open your Barron’s and look at the listing of closed-end funds, a quick glance will show that more funds trade at a discount than at a premium. You’ll see quite a few equity funds with discounts over 10% and even a few over 20%.
Discounts (and premiums) make no sense at all. According to the laws of finance, there should be just one price for an asset. Otherwise investors would buy it wherever it was cheap and immediately sell it where it was dear — until the asset’s price became the same everywhere. Since investors are always on the lookout for opportunity, why wouldn’t they buy the closed-end fund priced at a discount and then sell the components for their full value? That would be free money – immediately and at no risk.
But it doesn’t often happen – or even often enough to not make scholars wonder. Finance academics have been looking at the puzzle of persistent discounts for decades, and they’ve come up with possible explanations that come in two flavors. One is behavioral – that is, that closed-end fund discounts result from the irrationality of investors, or sentiment. The other is structural – that is, that there are market imperfections which prevent the discount from disappearing.
It’s been proposed that fees, taxation, and liquidity play a role. More specifically, investors may demand a discount because the fees a fund charges for management. Or the cost of arbitraging – which is the process of buying the fund and selling its components as we described above – is higher than it looks. If a fund holds illiquid assets, arbitrage will be more difficult. And in fact, it’s true that some of the funds with the largest, most persistent discounts are those with more illiquid assets, like real estate or emerging market stocks.
Another idea is that funds generate taxable events when they sell their holdings, and since investors can’t control when capital gains taxes will need to be paid, they require a discountfor those taxes, which will have to be paid eventually.
Whatever the reasons, it sometimes is hard not to be tempted by the discounts. The mispricings simply look too huge. But should you be? If you think the reason for the discount is mostly investor sentiment, you may have a case. Sentiment can and does change, though it requires patience to wait things out. But structural impediments like illiquidity can be more enduring.
Sorting it all out is difficult. But a historically large discount can be a sign of opportunity. Malkiel would say that even if discounts never disappear completely, it can be worthwhile to buy when discounts get very large and then look to sell as they shrink.
