Wild World of Closed-End Funds: Practically Guaranteed Returns
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| By Nilus Mattive |
I want to show you one of the craziest pricing errors in today’s market … and how you can take advantage of it.
Most investors are familiar with mutual funds and exchange-traded funds, both of which can offer single-shot access to entire portfolios of stocks, bonds and other types of traditional assets. But not as many people spend much time looking into closed-end funds (CEFs).
Like other types of funds, CEFs typically hold baskets of different underlying assets. The difference is in how they operate day to day.
For example, traditional mutual funds only trade once a day … and update their prices accordingly. They also adjust their share counts based on varying investor demands.
ETFs trade throughout the day. The companies running ETFs can also create or redeem shares to keep prices closer to the net asset value, or NAV, of their holdings.
Like ETFs, closed-end funds trade throughout the day. The difference is that they have a fixed number of shares upon creation. This means their issuing companies cannot make the same type of adjustments we see with mutual funds and ETFs.
The end result: Closed-end funds often trade at market prices that are different from their NAVs.
What’s more, the premiums or discounts can get quite extreme because of all types of factors — everything from investor interest to the liquidity of the underlying assets being held.
That makes CEFs a great place to hunt for bargains, and right now is an even better time than usual for several reasons …
For starters, we’ve just seen end-of-the-year selling take place.
It’s no secret that individual investors and professionals alike aim to cut losses before the end of every calendar year. Tax loss harvesting is the main reason, but there are also other forces at work.
For example, a hedge fund might want to get rid of underperformers before it closes its books in a process commonly known as “window dressing.” Or perhaps a particular CEF simply doesn’t fit an investor’s forecast for the year ahead, so the hedge fund gets rid of it.
Whatever the reason — or combination of reasons — we often see a lot of buying and selling in December and that can magnify the inherent variances in CEF pricing.
This past year, we saw even more. We started seeing some of the steepest discounts in CEF history over the past several months.
For example, according to analyst Nik Torkelson, CEFs focused on municipal bonds were trading at an average discount of 13.6% going into November 2023. That represented more than three times their normal discount of 4% and was the widest disconnect from their NAVs in more than 15 years.
As Torkelson said in his research note:
“For a firm that eats, sleeps and breathes discounted CEFs, this is the most compelling entry point we’ve seen in 15+ years.”
It’s true.
Looking at the wider world of CEFs — and using the latest data — we still see the same basic thing.
According to the Closed-End Fund Association, the typical CEF was trading at a 9.08% discount to the value of its assets at the end of January, with equity-focused CEFs going for an average discount of 10.05% and fixed-income CEFs just slightly less undervalued at an average discount of 8.25%.
How does that compare to discounts over the last 20 years?
Here’s a chart that shows the average discount on developed market CEFs (expressed as a positive for easier viewing) …
As you can see, the typical CEF was trading at a single-digit discount of 5.4% back in 2004.
And although discounts widened to 13.1% during the financial collapse in 2008, they currently stand at a much greater 16.4% right now.
This is a weird and wild opportunity in the market you won’t hear about anywhere else. If you can find the right CEF WITH a large discount to NAV, there’s never been a better time to take advantage of this market irregularity.
Best wishes,
Nilus
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