It is not often that we get the chance to buy a dollar for eighty five cents. But markets aren’t always rational, and that’s how we get our opportunity. I believe that every investor should implement a strategy of buying closed-end funds when they trade at a proper discount.
What’s a closed-end-fund (CEF)?
Almost all the funds you probably know are “open-end” funds. This means the fund will issue as many shares as investors are willing to buy. When investors put more money into the fund, the fund issues more shares and buys more shares of the underlying stocks. Because of this, the price you pay for a share of an open-end fund will always be the total value of the stocks in the fund divided by the current number of shares outstanding. This value is known as the “net asset value,” or NAV. Open-end funds always trade at their NAV.
Closed-end funds work differently. These funds issue a limited number of shares. If you want to buy these shares, you must go into the stock market where they trade like a normal stock. In other words, to buy a closed-end fund, by definition someone else must sell you their shares.
Since CEFs trade like normal stocks, the value of a closed-end fund can fluctuate significantly and does not necessarily reflect its NAV. Any difference between the share price and NAV of a closed-end fund is known as the premium or discount, depending on if the share price is higher or lower than the NAV. In theory, this situation makes no sense. Closed-end funds should never trade at a discount, and they certainly shouldn’t trade at a premium. After all, it would be foolish to sell a fund for less than it’s actually worth. And it definitely makes no sense to buy a fund for more than it’s worth.
But in the real world, it does happen. Whether it’s because someone has to sell for reasons unrelated to the fund, such as a margin call, or folks irrationally selling out of fear, like we saw in 2008 and 2009. Whatever the case may be, closed-end funds will sometimes sell at a significant discount to NAV. This can be a huge opportunity for savvy investors. It’s because under most circumstances, the fund’s share price will return to NAV. One of two things is going to happen–either the market will realize the fund is under-priced and drive the share price up, or the fund managers will get shareholder approval to buy back shares and remove the discount. It’s a win- win situation for the investor.