Are closed-end fund discounts rational?

November 19, 2016 09:00 AM
Closed-end funds (CEFs), unlike open-end mutual funds, trade on an exchange, in a manner akin to how an ETF trades.

Closed-end funds (CEFs), unlike open-end mutual funds, trade on an exchange, in a manner akin to how an ETF trades. They are “closed” in the sense that the sponsoring company, be it Franklin, BlackRock, Nuveen or any of a host of others, never have to raise cash to cover redemptions. If an investor wants out, they simply sell the shares on an exchange. The market price of a CEF is thus a simple product of supply and demand and as such can often deviate from the value of the assets it holds, known as its Net Asset Value (NAV).  Whereas for an ETF, where an authorized participant can and does keep the NAV and market price from diverging, no such mechanism exists with CEFs, and to the befuddlement of academics the market doesn’t automatically correct for this mispricing by itself.

This “mispricing” usually occurs at a discounted price to NAV, a finding that was first highlighted in the academic literature more than 50 years ago by Eugene Pratt. Since then, scores of papers have been written on the subject, yet the discount still persists. 

Closed-end fund discounts and premiums are incredibly interesting to academic researchers because they represent a direct assault on the efficient market hypothesis (EMH), which still persists despite a mountain of evidence disproving its efficacy and suggests that prices always reflect fundamental value. In fact, Burton Malkiel, of “A Random Walk Down Wall Street” fame, acknowledged a few years after his famous book was published that the then common explanations — namely unrealized capital appreciation, distribution policy and high fees — for the anomaly explained only a small fraction of the discount. The anomaly, he posited, represented “a market imperfection” more likely to be due to market psychology. 

Richard Thaler, a behavioral economist perhaps best known for his battles with the proponents of the EMH, teamed up with others in an article in the Journal of Economic Perspectives to argue that with limits to arbitrage, irrational demand can influence pricing. Likewise,  others have made a persuasive and similar case that the discount is due to the predominance of “noise traders,” who are driven more by sentiment than value, over rational investors.

So where does the research stand now and why are researchers still finding the anomaly worth writing about?

The recent research involves four sometimes competing, yet often complementary theories: Investor Sentiment, liquidity, manager ability/cost and rent-Extraction. 

Thaler and his team followed up their 1990 article by persuasively arguing that the empirical evidence for mean reversion within the anomaly points to investor sentiment as the correct theory. In other words, learning-impaired investors flock to the sector when optimistic thus reducing the discount and sometimes even creating premiums. On the flip side, too few rational investors are available to stave off the inevitable discount when pessimism prevails. Jeffrey Pontiff in a 1995 paper highlights that, as a result, investors can make money by simply buying the funds with the greatest discount. Another paper links the discount and the CBOE Volatility Index (VIX).

Academics’ unease with such a blatant behavioral explanation led to others theories such as the liquidity based theory of CEFs. Because funds are never forced to liquidate, the closed end fund structure allows for less liquid underlying securities not otherwise available to investors at a reasonable cost. In other words, they create liquidity for small investors to invest in less liquid assets. When those returns abate, the trade-off cost of high fees dominates the pricing and CEFs trade at a discount. This, too, explains why closed-end investors may flock in herds igniting waves of IPO offerings despite the eventual reality that odds favor them soon trading at a discount. 

Jerry Parwada and Kok Keng show in a 2014 paper that when reviewing CEF investor holdings, investors have less exposure to the assets in the CEFs they’re invested in.

Another explanation is that CEF investors are willing to pay premiums and sell at discounts to reflect perceived manager ability and the cost of their services in the form of fees. Jonathan Berk and Richard Stanton argue that in equilibrium, most investors will not want to pay the high fees without a history of strong performance and so in general, CEFs will trade at a discount. Perceived ability is highest when launching an IPO. 

In general, though, mediocre performance leads on average to a discount. This theory also better explains the observation that at any given time, various CEFs trade at premiums while others trade at discounts.

The simplest theory may be that CEFs are simply rent-extraction tools used by fund sponsors against naive investors. If that is the case, activists should be able to capture some of those rents. Activists have used the Security and Exchange Commission’s (SEC) proxy reforms in 1992 to both significantly increase their activities and reduce the discount level. Likewise, the SEC’s 2004 Regulation SHO, which relaxed short sale constraints, also has systematically shrunk the discount in the most affected CEFs.

Investors now have a myriad of alternative ETFs to choose from, even in what are deemed less liquid markets, including leveraged loans, emerging markets and high yield bonds. It’s harder to argue CEFs provide unique needed liquidity to retail investors. Still, the CEF anomaly appears alive and well (see “Premium play,” below). 

Second, throughout this time, fund sponsors like Pimco have often traded at a premium whereas other funds sponsors like BlackRock have traded at more of a discount. In general, the sector has traded at an overall discount, which is consistent with trade-off between manager ability with fees as predicted by the theory.

Finally, activists like Saba have been particularly active as many investors have seen numerous proxy letters involving the space. Arguably, their activity is partly responsible for the sectors strong performance in 2016.

Finally, CEFs, especially those within the fixed income space, tend to invest in very illiquid, often hard to value assets. Don’t get lulled into looking at the annual reports or factsheets. They only provide a cursory peak under the covers. A BB rated, very highly leverage collateralized loan obligation, for instance, may be reported simply as a benign asset backed security. Managers are motivated to support payouts and as such, they tend to invest in higher yield securities.

It is important to vote your shares based on the empirical evidence and facts, not rhetoric.

About the Author

Jonathan Seed, founder of RIA Seed Wealth Management, began his career at Franklin Asset Management Systems. His 20-year career on Wall Street focused on fixed income, with an emphasis on structured products.