Closed End Funds: Where Does That Discount Go?
Summary If you buy CEFs you are probably on the lookout for discounts to NAV. Buying on the cheap has its benefits, but doesn’t guarantee capital appreciation. It’s worth taking a few seconds to consider what can happen to a discount before jumping into CEF land. Who doesn’t like getting a good deal? And closed-end funds, or CEFs, are one of the best ways to do that in the investing world because they often trade below the value of their assets. But, just getting a cheap price doesn’t mean you’ll make out well. And before just buying for the discount, you should take a moment to think about what happens “next.” An odd beast I’ve described CEFs as the El Camino of the investment world. The El Camino, if you don’t know, is a car with a sedan/station wagon front attached to a pickup/flat bed rear end. It stands out, to say the least. Closed-end funds are similar in that they are a pooled investment vehicle like an open-end mutual fund, but they trade on stock exchanges like a stock with a set number of shares. That creates the interesting situation where a CEF can trade below the value of its portfolio, or net asset value. The NAV, as it’s called, is just the value of the portfolio divided by the number of shares outstanding. That can never happen in the open-end world, because open-end mutual fund companies stand ready to buy and sell shares at NAV when the market closes every day. So, CEFs often present great opportunities to buy on the cheap. Adams Express (NYSE: ADX ) is a good example. Right now it trades at around a 14% discount to NAV. So, for every dollar you spend buying Adams you get $1.14 or so worth of stock. Great! Your yield is also higher than it otherwise might be. For example , based on Adams Express’ year-end 2014 price ($13.68) and full year distributions ($1.18 per share), its trailing yield was 8.6%. That, however, is higher than the yield of 7.4% when it’s based on the year end NAV of $15.87 a share. So, there are good reasons to like CEFs trading at discounts. However, according to the Closed-End Fund Association , Adams Express’ discount over the trailing five years is about 14%. Over the trailing decade it’s… about 14%. While the discount goes up and down over time, you should probably expect Adams to trade at about a 14% discount all the time. Yes, you are benefiting in some ways from the price discrepancy, but you’re probably not going to benefit from a narrowing of that spread. Up and down So, a persistent discount is one possible outcome with a CEF. But what else could happen. The most desirable outcome, obviously, is for the price of the CEF to rise and close the gap. That would result in capital gains. A recent example of this is exactly what’s taken place at GAMCO Global Gold, Natural Resources & Income Trust (NYSEMKT: GGN ) and GAMCO Natural Resources, Gold&Income Trust (NYSE: GNT ). This pair of precious metals and natural resources funds were trading at discounts of 5% and 6%, respectively, early in January. In just a few weeks those discounts had narrowed to 1% and 4%, respectively. That led to capital appreciation of 8% for GGN and 5.5% for GNT. Annualized, those are huge gains. This particular trade was most likely made possible by year-end tax loss selling. GGN and GNT have a habit of seeing their discounts widen at the end of the year only to narrow as the new year progresses. This is, in the end, ideal: Buy something on the cheap and then watch as other investors realize it’s cheap and bid the price up. But, this works both ways. If you had purchased GGN on June 2nd last year it would have cost you around $10.29 a share. The NAV at that point was $10.07 a share. That is, in fact, a premium of about 2%. By January 27th of this year, the price had declined to $7.70 a share, with the NAV falling only to $7.84 – resulting in a discount of around 2%. Now, clearly, oil prices falling off a cliff had something to do with GGN’s price decline since it has notable exposure to the energy industry. But, this example shows very clearly that the difference between price and NAV works both ways. And, you can wind up a loser if the change between the two goes against you. This is exactly why buying a fund at a premium can be so risky. PIMCO High Income Fund (NYSE: PHK ) is an extreme example of this right now since it’s currently trading hands at an over 50% premium. If the difference between price and NAV narrows because the price falls toward the NAV, investors could feel a lot of pain. Although I don’t expect this to happen with PHK, there’s also the chance that the NAV of a fund trading with a premium could rise while the market price stagnates. That would narrow the discrepancy and bring things closer to a rational relationship. However, it would do very little for shareholders since the market price would have to sit and do nothing for this to happen. Looking at the flip of that, a fund with a discount could see the NAV stagnate and the market price of the shares rise, narrowing the discount. That would, obviously, lead to capital appreciation. Options! That, however, is just as unlikely as PHK’s market price flat lining, since the only constant on Wall Street is change. But it’s a good thought experiment to consider all of these possibilities because it prepares you for what could happen. That’s particularly important because the unusual relationship between price and NAV for closed-end funds can be confusing and, perhaps, lead you to rash decisions if you haven’t given this nuance enough consideration. So, to make things really confusing: a discount can narrow because the market price of a CEF goes up while the NAV stagnates, because it goes up faster than the NAV is rising, or because it goes up while the NAV is going down. A discount can expand and a premium disappear because the share price falls while the NAV is stagnant, the share price falls faster than the NAV is falling, because the NAV goes up while the share price goes down, or because the NAV goes up faster than the share price. The relationship between the NAV and share price can also just stay the same, as Adams Express shows. There are, clearly, a lot of possible outcomes, and I might have missed some. But, complexity shouldn’t stop you from giving this some thought because you might see any of the above changes taking place at any given time. And, you’ll want to understand before that happens what it means for your investment outcome. In the end, if the only thing you take away from this is that PHK is trading at a dangerously high premium, that’s good enough for me. But, I hope you’ll take a moment to meditate on CEF discounts and premiums – it’s better to prepare with knowledge than react poorly to something about which you could have forewarned yourself.
