Description
This article is from the A Guide to
Closed-End Funds (CEFs).
Investing in CEFs: Leverage of Discount
CEFs, when purchased at a discount, offer a form of free leverage,
where no margin interest is paid. The wider the discount, the larger
is the leverage. This leverage can dramatically improve the returns
of the investment.
Consider, for example, a CEF with a NAV of $10 trading at a
discount of 20% or $8. Assume that, over a reasonable period of time,
the market moves up and the NAV of the fund has doubled (i.e., moved
up by 100%) to $20. At this time, the fund returns $10 to the investor
in the form of capital gains distributions, leaving the NAV at the
point where we started $10. Suppose the discount hasn't changed over
this period, and is still 20%, that is, the fund is trading at $8. If
the investor exits at this point, his profit is 125% ($10/$8),
substantially better than the 100% return on NAV. The reason is
simple: with $8 of his money, the investor controlled $10 worth of
securities held by the fund; accordingly his returns were much higher
than an outside investor who bought the same securities in the market
rather than through the CEF.
Similarly, if the CEF was bought at a 50% discount, a 100% return
on the NAV would translate to a 200% return to the CEF investor, even
if the discount stayed at 50% throughout this period. Note also, that
unlike leveraging through margin accounts, no interest is paid.
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CEFs, closed-end fund, premium, discount, volatility, trading, investing, leverage, yields, buying, selling, shares, money, funds, mutual funds, adventages, disadvantages, liquidity, commissions, brokers, source, information, reference
