Control over price of the funds' shares
Description
This article is from the A Guide to Closed-End Funds (CEFs).
Control over price of the funds' shares
With a mutual fund, the price at which the individual investor can buy or sell shares is set at the NAV. With a CEF, the individual investor has opportunities to time his purchase and sale of shares that may increase his profits and minimize his risks.
- Leverage of Shrinking Discount.
- Apart from hoping that the market in which the fund invests, and accordingly the NAV of the fund, will go up, an investor in CEFs has the opportunity to capitalize on an additional factor that affects performance: the shrinking discount. In some cases, the difference in the NAV and market price performance can be dramatic.
- Leverage of Large Discount.
- What if the discount does not shrink, but remains steady? Even in such a case, an investor who buys a CEF at a large discount may benefit from a higher yield. Consider a CEF with a NAV of $10, trading at a discount of 20% (that is, $8). Suppose, the yield from the CEF is 10%. Since the yield is based on the NAV of the fund, the investor gets a return of $1. However, since the investor bought the fund for $8, his effective yield is much higher: 12.5% ($1/$8). Contrast this with a mutual fund investor who invests $10/share and whose yield remains at 10%.
- Protection of Wide Discount.
- The discount, when utilized properly, may provide the CEF investor with some protection against market downturns. In some cases, if the CEF investor buys a CEF at an unusually large discount, the market price of the fund may actually rise, even though the market and the NAV drop. Sounds too good to be true? Look at this recent example:
Consider a CEF with a NAV of $10 that is trading at a 20% discount (that is, $8). Suppose the market moves substantially, say 50%, over a period of time, and the NAV of the fund tracks the market performance, moving from $10 to $15. This performance may cause a shift in investor sentiment and, assuming an extreme case, suppose the fund now trades at a 20% premium (that is, $18). An investor in the CEF would show a performance of 125% (from $8 to $18) over that period, even though the market and the NAV have moved only 50%. An investor in a mutual fund, not having the opportunity to buy at a discount and sell at a premium, would have only a 50% gain (this too, assuming that the fund was fully invested).
For an investor in mutual funds, such an opportunity to curtail risk is not available: if the NAV drops, the investor loses money.
The CEF investor may, if lucky, be provided with an unusual type of protection against sharp drops in the NAV: the market price often does not drop as sharply or as immediately, providing an opportunity to bail out with smaller losses. Look at the behavior of the Mexico Equity & Income Fund after the sudden devaluation of the peso.
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