The past several years have been challenging for investors. An elevated stock market and interest rate volatility caused by both inflation and a hawkish Fed sent many investors rushing to the sidelines. This dynamic led to indiscriminate selling and, at times, pushed closed-end fund prices lower, driving discounts to historically wide levels.
In fact, after the Federal Reserve started raising interest rates in 2022, a great deal of closed-end funds traded at their widest discounts since the Global Financial Crisis.
What are discounts?
A closed-end fund can trade at a share price that is higher or lower than its net asst value (NAV). When a fund's share price is higher than its NAV, it is trading at a premium. When the share price is lower than its NAV, it is trading at a discount. A discount or a premium is simply a number representing the relationship between a fund's share price and its NAV (Figure 1).
Figure 1. Premiums vs. discounts
Source: abrdn. For illustrative purposes only.
Closed-end funds often trade at discounts, but over the course of a market cycle it has historically been the case that the discounts narrow and widen, like how the stock market rises and falls.
During volatile markets, discounts can widen significantly, offering investors the opportunity to purchase shares well below their NAV. Many investors prefer purchasing closed-end funds at a wide discount because purchasing at a discount increases a fund's distribution rate and may present a higher potential for capital appreciation if the discount narrows due to the price rising to NAV. Because, as many investors fail to realize, discounts can also narrow as NAV falls to the price. Again, a discount or premium is simply a relationship between two numbers – nothing more.
Other investors are less focused on discounts and prefer to invest in a fund due to the fund's investment objective and its ability to provide regular distribution payments.
“Oh, it's a 10% discount, that looks good.” Well, unbeknownst to investors, the fund may always be trading at a 15% discount, and this 10% discount isn't much of a bargain. Furthermore, a closed-end fund discount could be driven by many different factors: poor historical performance, low distribution levels relative to peers, or market expectations of poor performance to come.
We believe it’s important to gain an understanding of what is behind the discount.
We believe it's important to gain an understanding of what is behind the discount. If no reason can be found, or if the only reason is the fund’s underlying asset class seems to be out of favor, those may be signs the fund's discount is truly attractive. Traditionally, contrarian investors were attracted to closed-end funds because those investors understood discounts were largely driven by cyclical sentiment eventually swinging back into favor.
Distributions, distributions, distributions
Despite closed-end fund investors' love affair with discounts, distributions – not discounts – have historically been the primary contributor to total returns over longer periods of time.
Most closed-end funds are designed with the goal of providing attractive, regular distributions to shareholders – and have long been valued for the distribution payments and diversification benefits they may offer. While closed-end fund distributions would naturally be expected to positively contribute to returns, over longer periods distributions become an increasingly larger positive component of total return while the change in discounts contribute increasingly less to total return.
The benefit from a narrowing discount diminishes over time as a contributor to overall total return while distributions remain the dominant contributor.
Consider a fund that distributes 7% of NAV per year and has an 10% discount. If the fund is held for three years, assuming its NAV does not change, and its price rises to the NAV at the end of the three-year period the distribution would account for roughly two-thirds of the price return every year (Table 1).
Table 1. Most of return should come through distribution
Source: abrdn. For illustrative purposes only.
Therefore, investors may be better served by focusing on a fund's distribution than on the fund's discount.
Final thoughts
While it's exciting to follow a closed-end fund's discount, it's ultimately not value-additive. Once invested, the most important thing to assess is the fund's total return performance and whether it is meeting investment objectives. Historically, the key, long-term driver of a fund's performance has not been its discount, but its distribution rate.
Important information
Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund's investment return and principal value will fluctuate so that an investor's shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund's portfolio. There is no assurance that the Fund will achieve its investment objective. Past performance does not guarantee future results.
The use of leverage will also increase market exposure and magnify risk.
Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Open-end funds can be bought or sold at the end of each trading day at their net asset values (NAVs). Because closed-end funds trade throughout the day on an exchange, the supply and demand for the shares determine their market price; closed-end funds'; market prices may fluctuate through the trading day and those prices may be higher or lower than their NAVs. Closed-end funds and mutual funds charge investors annual fees and expenses. All of these products may use leverage to enhance their returns, which can magnify a fund's gains as well as its losses. Closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. Both vehicles seek to deliver returns based on their investment objectives, but neither is FDIC insured. The Revenue Act of 1936 established guidelines for the taxation of funds, while the Investment Company Act of 1940 governs their structure. Aberdeen Standard Investments does not provide tax or legal advice; please consult your tax and/or legal advisor.
AA-010224-173677-1