Closed-End Fund (CEF) Discounts and Premiums - Fidelity

Please enter a valid email address Please enter a valid email address Important legal information about the email you will be sending. By using this service, you agree to input your real email address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an email. All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity.com: " Your email has been sent.

Mutual Funds and Mutual Fund Investing - Fidelity Investments

Clicking a link will open a new window. CEFs have an underlying portfolio of securities. From this portfolio, a net asset value (NAV) can be derived [NAV = (assets − liabilities) ÷ shares outstanding]. The investment portfolio primarily, if not solely, comprises the assets. For leveraged CEFs, the leverage itself is the bulk of the liabilities. CEFs trade on an exchange. This means that they have a share price, which is set by the market. These 2 prices, the NAV and the share price, are rarely the same, and when they are, it's only by coincidence. The differences between the share price and the NAV create discounts and premiums. Shares are said to trade at a "discount" when the share price is lower than the NAV. The discount is commonly denoted with a minus ("−") sign. Shares are said to trade at a "premium" when the share price is higher than the NAV. The premium is commonly denoted with a plus ("+") sign. The calculation is (share price ÷ NAV) − 1. Examples: Share price = $19.00
NAV = $20.00
Discount = ($19.00 ÷ $20.00) − 1 = 0.95 − 1 = −0.05 = −5.0% Share price = $12.00
NAV = $10.00
Premium = ($12.00 ÷ $10.00) − 1 = 1.20 − 1 = +0.20 = +20.0% See for closed-ended funds.

What gives rise to discounts and premiums Why is the market seemingly inefficient

Efficient market hypothesists have tried to decipher discounts and premiums for years with myriad explanations. Most commonly, the reason a CEF trades at any given discount or premium is related to the fund's distribution rate, regardless of the source of the distribution. (Some fund families seemingly abuse the knowledge that this occurs to justify—in their minds, not ours—the use of destructive return of capital.) Other typical reasons for premiums and discounts include: Overall market volatility Recent NAV and share price performance Brand recognition of fund family Name recognition (or lack thereof) of the fund manager Recent changes in distribution policy An asset class or investment strategy falling out of market favor An asset class or investment strategy rising in the market's esteem Whatever the reason for a CEF's discount or premium pricing, it is crucial that CEF investors realize that discounts and premiums exist. At Morningstar, when comparing a share price with a NAV, we often refer to discounts and premiums as "Absolute Discounts" and "Absolute Premiums." We do this because, there are other ways to look at discounts and premiums. For instance, if we compare a CEF's discount to its average historic discount, this is what we refer to as a "Relative Discount." Most long-term investors just look at Absolute Discounts and Absolute Premiums. But when considering valuation, it's important to look at Relative Discounts and Relative Premiums. There are 3 things to consider regarding discounts and premiums: Regardless of the discount or premium, what matters to an investor is the share price at the time of purchase and the subsequent total return of the CEF. A CEF's discount or premium tends to persist. If the CEF typically trades at a large discount, it will tend to stay at a large discount, barring any corporate actions from the board of directors. The same can be said of premiums. Even in periods of extreme market volatility, CEFs that typically trade far below or far above the universe's average discount will more than likely continue to trade that way, even if during the downturn the premium turns to a discount. Over a complete market cycle, most CEF share prices will trade below, at, and above their corresponding NAVs.

Absolute discounts

The standard thinking for CEFs is to focus on funds trading at discounts and to avoid funds trading at premiums. We think this maxim is simplistic and could lead to unrealistic expectations for investors. All that matters for a CEF investor is the share price at which the CEF was purchased and the subsequent total return. Discounts and premiums wax and wane over time. For instance, if a CEF is trading at a 15% discount, people often tout this as an opportunity to buy $1.00 of assets for $0.85. The unstated premise is that eventually the price will reach $1.00. This is problematic. Nothing mandates that a share price, even discounted at 15% to NAV, must converge to its NAV over time. Furthermore, the NAV could decline to $0.85 (or lower). We recommend not purchasing CEFs at absolute discounts in the hope that the share price will converge to a higher NAV. The primary benefit of purchasing a CEF at an absolute discount is for income-seeking investors to enhance their yield.

Yield enhancement and absolute discounts

Putting aside sources of distribution, let's assume that a fund's underlying portfolio at NAV yields 10%. Distribution = $1.00 per share
Net asset value = $10.00
Distribution rate at net asset value = $1.00 ÷ $10.00) = 10% Let's further assume that the shares trade at a 10% absolute discount. Net asset value = $10.00 per share
Share price = $9.00
Absolute discount = (share price − NAV) / NAV = ($9 − $10) / $10 = −10% Because they are buying at a discount, investors purchasing these shares will get a higher yield: Distribution = $1.00 per share
Share price = $9.00 per share
Distribution rate at share price = $1.00 ÷ $9.00 = 11.1% So, "Yield enhancement" = dist rate (share price) ÷ dist rate (NAV) = 11.1% ÷ 10% = 1.1% See for closed-ended funds. Buying $1.00 of assets for $0.85 isn't necessarily a bargain. The table below sets forth the 9 scenarios that can play out when purchasing shares at an absolute discount. Get industry-leading investment analysis. Check to see which closed-end funds we offer. Learn how closed end funds, mutual funds, and ETFs differ. 2012 Morningstar, Inc. All Right Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Article copyright 2012 by Morningstar, Inc. Reprinted with permission from Morningstar, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Please enter a valid e-mail address Please enter a valid e-mail address Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.

Your e-mail has been sent. Closed-end funds may trade at a discount (or premium) to their NAV and are subject to the market fluctuations of their underlying investments. Shares of closed-end funds frequently trade at a market price that is a discount to their NAV. Closed-end funds are subject to management fees and other expenses. The Closed-End Fund Screener may include closed-end funds not registered under the Investment Company Act of 1940. 626405.3.0

Footer

Stay Connected