Zaks Investment Advisory Service

About Closed-End Funds, the Mystery of Discounts, and Arbitrage

Imagine that you are sitting in front of a box with a $100 bill locked inside it. The box owner offers to sell you the box for $80. You agree, but after a while you decide that you really have no need for a box with a locked bill, and you sell it on to someone else for the same $80. A similar situation occurs with Closed-End Funds. We talked about them in our last program. I mentioned how when they are created, Closed-End Funds issue a certain amount of shares in an Initial Public Offering. They use that money to purchase securities matching the fund’s investment policy. In contrast to Mutual Funds, the number of shares in a Closed-End Fund is constant; they are traded on the open market, and investors buy its shares from each on the open market: when one investor buys the shares, that means another one sells them. Closed-End Funds are a fairly rare type of financial instrument: as we mentioned, there are only about 700 of them (as opposed to 8,000 “regular” Mutual Funds). Nevertheless, Closed-End Funds, in a certain sense, are very interesting instruments. They represent a paradox that contradicts our understanding of how financial markets function.

The fact of the matter is that share prices of Closed-End Fund usually differ from the Net Asset Value of the fund itself. The Net Asset Value (NAV for short) is the value of all of the fund’s assets (i.e. in practice, the value of all of the fund’s securities) minus the value of all of its liabilities, i.e. the things that the fund so-to-speak “owes.” Funds have very few debts compared to assets: payments to fund managers, current employee salaries, etc. This is relative small-change compared to the fund’s assets (which on average stand at hundreds of millions of dollars), so that the fund’s NAV is usually close to the value of all of its purchased securities. Let us imagine that for a single share of the fund, the NAV comes to $100, i.e. the fund has about $100 of securities per share. Meanwhile on the open market, these shares are traded at $85, i.e. “at a discount” of 15 percent. In case of our example, the $100 NAV is the $100 bill, and a share of the fund is the box in which the bill is locked.

A paradoxical situation occurs: the fund’s share represents the aggregate of securities worth $100, for which no one wants to pay more than $85. And the seller agrees to this price. In other words, something that theoretically costs $100 is bought and sold at $85! This sounds unreasonable and completely fails to fit with our understanding of how financial markets function.

By the way, last time I mentioned a fund, Templeton Russia Funds (TRF), which mostly invests in shares of Russian companies. TRF is rather unusual in a sense that its price often exceeds that of its NAV, i.e. it sells “at a premium.” Usually Closed-End Funds sell at a price below their NAV, i.e. “at a discount.” In recent years, the discount of a Closed-End Fund on average stood at 15 percent. It is not uncommon for the discount or premium to reach 40 percent or even more.

This situation is so unusual that many researchers have tried their hand at explaining why the market price should differ so much from the NAV, and also why, on average, Closed-End Funds sell at a discount.

Many ideas were proposed, both economic and behavioral in nature. They usually came down to problems related to the fund’s taxes, manager compensation, and those managers’ reluctance to close the Closed-End funds, selling their assets and returning the money to shareholders. Unfortunately, each of these theories has its flaws, and none of them completely explains the discount phenomenon. The behavior of Closed-End Funds remains a mystery to this day.

We, investors, are less interested in theory than the very fact that there is a difference between the NAV and the price, whether at a discount or premium. So a question arises: is it somehow possible to take advantage of this? It sounds very tempting: for example, to buy shares of some Closed-End Fund at $80 at a time when its NAV is $100, and then try to find a way of earning the $20 difference.

An attempt to earn money off temporary fluctuations in price is called arbitrage. Arbitrage is a very important concept. Thanks to arbitrage, stock and bond prices behave in a “reasonable” manner. Here is an example of arbitrage: suppose that IBM shares cost $105 in New York and $110 in London. Arbitrageurs would start buying up the IBM shares in New York and selling them in London. As a result, the IBM shares in New York would start gaining value while those in London – losing it. This would be happening until the two prices even out.

Despite the obvious spread in price between fund shares and those shares’ asset value, no real opportunity for arbitrage has yet been found. And this is understandable: if it were easy to conduct arbitrage, then there would be no premium or discount. Nevertheless, interesting Closed-End Fund investment strategies do exist.

With this we will have to close for the day. This was Sergey Zaks. Thank you for your attention and until next time.