“How do you buy shares of closed end funds selling at a discount? Why would they be selling at a discount? I thought that closed funds meant that you can’t get into them.”
Some open-ended mutual funds close temporarily (or permanently) to new investors — but that’s an entirely different thing. To redeem your shares, you still send them to the mutual fund company and get 100% of their then net asset value.
A closed-end fund is sold like a new stock, typically at $10 a share. Never buy them on the offering, because the underwriter takes his fee out of your funds and you are in effect paying $10 for $9.50 (or whatever) in assets.
But after the initial public offering — perhaps 20 million shares are sold at $10 each — the only way to buy the shares is from someone who sells them. And the only way to sell them is on the open market to someone who wants to buy them (i.e., you can’t redeem them with the fund company). Typically, they sell at a discount for several reasons.
One is that most money managers can’t beat the averages — so why pay 100 cents on the dollar for assets out of which is typically taken 1% a year in management fees? If GM is worth $50 a share, wouldn’t GM’s performance-minus-1%-a-year be worth only $45, if that? Well, a closed-end fund may own GM and 50 other stocks, and the same reasoning applies to the whole batch.
If you think this money manager can outperform the market by 1%, thus covering his fee and matching the market, then the fund should sell at 100 cents on the dollar. If you think she cannot just beat the market by enough to pay her own fee but add an extra 1% or 2% or 5% of performance to boot — as few can — then you might reasonably pay a premium.
Another reason closed-ends typically sell for a discount is that people know they do, expect them to — and thus resist bidding them up to full value. Or look at it this way. They know closed-ends rarely sell at a premium but can drop to 90% or 80% or in a bad market perhaps even 70% or 65% of net asset value. (Some, of course, will do better than others.) Knowing that, why risk paying 100 cents on the dollar. You expect a bit of a bargain to induce you to take this extra risk.
Theoretically, closed-end managers could end the discount and enrich their owners by going “open-end” — i.e., offering to redeem whatever shares were tendered at net asset value. Suddenly, each $1 of assets would be redeemable for $1, so the fund would sell for about 100% of its value.
But that could mean less money under management and, in turn, less money for the fund manager. So instead they often do the opposite. Rather than offer to redeem your existing shares, they “force” you to buy more. How? By offering you and all the other shareholders the “right” to buy additional shares at 5% or more “off” the going market price.
You’re not literally forced to buy, of course; but if you don’t, your own shares become a little diluted in value by the discount given those who do accept the offer.
(Closed-ends know many shareholders don’t like these rights offerings but make them anyway to expand the pool of capital they have under management, from which they can take fees.)
In short, closed-ends can offer great value. Or not. Only buy them when they do.
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