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Closed-End Funds: Understand What You're Buying

by: Saj Karsan October 15, 2008 | about stocks: EQS    

Saj Karsan

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A few months ago, we considered the discounts to net asset value that a few closed-end mutual funds were trading at. Basically, this means that these funds could be purchased for less than the value of what they owned. Due to the recent decline in the general stock market, the prices of many closed-end funds have taken a large beating.

Below is a graph showing the percentage of net asset value that the median closed-end fund trades at (thanks to Kevin Gates for putting this together using Bloomberg):

click to enlarge

At first glance, it appears that closed-end funds are trading at tremendous discounts by historical standards. While the chart indicates that the median fund trades at more than a 25% discount to its net assets, investors must pay careful attention!

If you're considering the purchase of a closed-end fund due to its discount, you must consider several factors. First of all, how up to date is the net asset value calculation? If the NAV listed is from 10 days ago, and the market has dropped since then, the price of the fund might be low but the NAV is lower than is shown.

Second, many funds own assets that are not part of the stock market. In these cases, management has some discretion over the methodology used in the determination of the fair value of such securities. As was raised in an SEC speech here, fund ownership of illiquid securities can lead to NAV valuation inaccuracies that can mislead investors. We met this valuation challenge when we looked at Equus (EQS), a fund concentrating in the alternative energy space.

Don't buy a closed-end fund blindly due to its discount! Understand what the fund owns, when its assets were valued, and how much you can trust that valuation (i.e. are its assets traded on a liquid public market, or is some other valuation metric used).

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This article has 3 comments:

  •  
    Oct 15 08:28 AM
    It's also worth noting that many closed end funds are thinly traded, causing larger price volatility when large holders liquidate. This will smooth out in the long run of course, but will cause the short term investor real concern.
    Reply
  •  
    Oct 15 08:37 AM
    Better check out whether or not a CEF with a large discount also has a large use of leverage. A large leverage could spell serious problems ahead for a CEF.
    Reply
  •  
    Oct 21 12:04 PM
    I've also noticed that some CEF's have exposure to foreign exchange contracts, which could definitely have some impact on NAV calculations.
    Reply
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