If someone offered you the chance to buy assets worth £1 for 85p, you’d probably dismiss the offer in the same way you would an email purporting to be from a deposed African dictator looking for someone with whom to share his fortune.
Yet that, and more besides, is exactly what’s on offer from many closed-end funds.
What Is the Discount?
The share price of a closed-end fund is, like that of any listed company, determined by supply and demand for its shares. As such, a fund’s share price can diverge from its net asset value (NAV): When the share price is lower than the NAV, the fund is said to be trading at a discount; if higher than the NAV, the fund is referred to as being at a premium.
Buying into fund at a 15% discount means that you’re effectively paying 85p for £1’s worth of assets; if this hypothetical fund is also paying a 5p annual dividend, you can obtain a yield of 5.9% rather than the 5% you would achieve through buying an equivalent open-ended fund at the NAV of £1.
Reasons For the Discount?
Being permanent capital vehicles, the supply of shares is relatively fixed so attempts to explain closed-end fund discounts have concentrated on the factors affecting demand for shares. Numerous academic studies have sought to find a rationale, often with conflicting results. Some of the reasons cited include the illiquidity of the underlying assets, past performance, future management fees, and scepticism of the reliability of NAVs. Of course, certain sectors will be in vogue at different times—at the end of 2007, the London-listed funds of hedge funds sector was trading at a small weighted average premium but now finds itself at a 14% discount.
Profiting From the Discount
Discount volatility: The discount of closed-end funds is a good measure of the ‘fear-level’ in the market, widening out in times of trouble as investors run for the exit, and narrowing in bull markets when increased demand for funds’ shares compresses the discount. Savvy investors can profit from this discount volatility, a good case in point being found in the Morningstar Investment Trust UK Smaller Companies Peer Group.
The financial turmoil of late 2008 saw the size-weighted discount of this sector hit its widest recorded level of 24% on November 25 of that year. One year later and the discount has narrowed to 17%, meaning that investors buying in at the sector’s nadir would have realised a total return of 75% up to the time of writing, even though the sector’s NAV performance of 58% has lagged the 60% return of the FTSE Smallcap index.
Of course, the discount can work against you if it widens after you have bought into a fund, resulting in exaggerated losses. Anyone buying into this sector when its discount was at its narrowest (10% on October 18, 2006) would have experienced a 54% fall in share price terms up to now even though the NAV ‘only’ fell by 45%.
Discount strategies : In one way or another, many hedge funds and proprietary trading desks at investment banks trading closed-end funds will rely on the concept of mean reversion to profit from discount volatility. Simply stated, mean reversion when applied to closed-end fund discounts says that discounts will eventually move back to their long-term average level. Of course, funds may find a new average level but that doesn’t mean that the strategy is without merit, more that additional research should always be undertaken to supplement the initial statistical filter.
Proponents of this approach will look at a statistical measure known as the Z Stat, which shows how many standard deviations the current discount is from its mean. For instance, a discount will be two standard deviations wider than its average only 2.5% of the time so, on occasions when a fund’s discount reaches this level, it will be a very attractive investment unless there is a good reason to suspect it will stay at this level (perhaps due to a change to a less popular, or more risky, investment strategy).
Of course, it’s all very well buying into a fund and seeing the discount narrow, but if the NAV falls significantly as well you can still end up losing money. Imagine if a fund’s share price was 70p and had a NAV of £1, putting it on a 30% discount. If the NAV fell to 60p and the share price went down to 55p, the discount has narrowed from 30% to 8%, but you’ve still lost over 20% of your initial investment. To counter this, these investors will often seek to hedge their exposure to the fund’s underlying assets so they can benefit from the discount narrowing even if the NAV falls.
Rather than waiting for nature to take its course, some closed-end investors will take a more hands-on approach. These activist investors will pressure the fund to take action to reduce the discount, whether through holding a tender offer at NAV, then realising assets and returning cash to shareholders, or perhaps converting into an open-ended fund. If the board seems reluctant to address their concerns, the activist will sometimes seek to have their representatives elected to the board to replace the incumbents. In a well publicised spat in the first half of this year, the board and management of Principle Capital Investment Trust were ousted, only for them to regain control of the fund a month later!
As you might expect, the appearance of an activist on the shareholder register isn’t a particularly welcome sight from the point of view of a fund’s board or manager, but the existence of these investors in the market helps to keep discounts narrower than they would otherwise be.
Minimising the Discount
To keep discounts from growing too wide, many funds have implemented discount control measures. These can include buying back shares in the market, or promises to hold continuation resolutions on the fund’s future in the event of the discount breaching a pre-specified trigger. The announcement of a discount level at which a fund will take action can itself serve to keep the discount narrow—if the discount drifted out beyond that level, the knowledge that steps will be taken to reduce it will often itself prompt new buyers of the shares. However, the credibility of the commitment is key—if investors don’t believe the fund will defend the discount target, there may be little appetite for the fund’s shares even at discount levels beyond the specified target.
Summing Up
Despite the need to consider the discount when assessing a closed-end fund, it’s important to recognise that it is only one factor to be taken into account: the asset class in which you’re invested and the skills of the fund manager will often have more of a bearing on performance over the long term. Nevertheless, the discount can and does have a significant impact on returns and is what makes closed-end funds such interesting and potentially profitable investment vehicles.
Next week, we take a look at another aspect of closed-end funds: Gearing. You can read our first installment of investment trust articles here.
