The Closed-End Fund Puzzle: One Man’s Loss, Another Man’s Gain

Closed-end funds are business entities that invest in securities and financial instruments as a way of making profits and losses. Unlike other funds, closed-end funds have their number of shares fixed and as a result their share price is determined directly by the interests of buyers and sellers in the market. The famous closed-end fund puzzle kicks in because these funds often trade at a discount to their net asset value months after they are offered and traded on public exchanges.

One of the explanations for this discount is investor sentiment. Most U.S. shareholders of closed-end funds are retail investors that sometimes are not as rational as the market would like it to be. As a result, closed-end fund prices unfortunately trade away from the net asset value of their underlying holdings. Furthermore, the persistency of the closed-end fund discount can also be attributed to the enormous cost of arbitrage.  For the efficient market to work, arbitragers need to be able to replicate the fund’s portfolio and go long or short on the fund. Because some of the underlying instruments in funds are so illiquid, transaction costs for arbitragers can often be very high. It can thus often be impossible for institutional arbitragers to narrow the discount to net asset value in any given period.

As of last Friday’s market close, there are 476 listed closed-end funds on the American stock exchanges. Out of all the American-listed funds, 48 percent of them traded at a discount to net asset value of more than two percent while only 27 percent of them traded at a premium to net asset value of more than two percent. Should we believe in the efficiency of the market, then share prices of such funds should closely track the fund’s net asset value.

One man’s misfortune is sometimes another man’s gain. To take advantage of this discount to underlying assets, we have screened a list of top ten discounted funds that can be traded on the Kapitall platform:

1. Equus Total Return, Inc. (NYSE:EQS) (Earnings, Analysts, Financials): The Fund’s investment objective is to maximize the total return to the Company’s stockholders in the form of current investment income and long-term capital gains by investing in the debt and equity securities of small and middle market capitalization companies that are generally not publicly traded at the time of its investment.

Trading at a 26% discount to net asset value