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Articles / TULARC / Investing / A Guide to CEFs / |  |
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Potential Disadvantages of Investing in CEFs: Shrinking Premium |
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This article is from the A Guide to Closed-End Funds (CEFs).
The leverage of the discount/premium can be a double-edged sword. If the CEF is bought at a wide discount, the market moves up, and the discount shrinks or changes to a premium, the investor benefits from the leverage provided by the shrinking discount. However, if the CEF is bought at a steep premium, the market moves down, and the premium evaporates or changes to a discount, the investor gets hammered by both the drop in the NAV and the shrinking premium.
Clearly, the CEF investor has to be extra-cautious and should refrain from investing at premiums or historically shallow discounts: though the market may continue to move up and he may profit, the risks of a downturn are large and usually outweigh the potential profits. Apart from the risk in the premium/discount, such situations usually occur at market tops, when the risk of a market downturn is also high.
On the positive side, CEFs trading at unusually large premiums or historically shallow discounts may provide an opportunity for the savvy investor to sell the CEFs short, betting that the market and the premiums will go down. Even if the market moves up, the CEF price may go down so that the CEF resumes its customary discount/premium level. For example, towards the end of 1994, many of the country funds were trading at outrageous premiums. Most of the premiums quickly collapsed when many of these markets moved down in the following months. Such opportunities are rarely available for the mutual fund investor. At best, he can switch to cash, but he can rarely profit from a down market.
Selling short can be very risky and may lead to unlimited losses. You should consult a professional before taking up such positions. Sometimes, selling short may not be feasible because shares of the CEF may not be available.
Continue to:
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
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