For over 50 years, academics have pondered the persistent discounts which closed end funds trade at relative to their Net Asset Values (NAVs).
Yet the discount still persists. Some of it can be explained by the funds’ typically high fees, although that begs the question; if investors were savvy enough to discount for the fees, why do they invest at all in open end mutual funds which have similarly high fees? And why do the sometimes trade at premiums?
More recent research highlights the correlation between investor sentiment and the discount. Regardless of the cause, the degree of discount fluctuates and a simple strategy of buying when the discount drops below their historical average and selling as the NAV/Price multiple approach premiums can add incremental return. Sometimes.
As the financial crisis showed, discounts can approach 30% and were even 40% and more in the early 1970s. Closed end fund risks are often misunderstood or ignored as retail investors and their brokers are lured into the sector by tantalizingly high yields. We feel the biggest risk is liquidity, heightened by leverage in many funds. While most funds have voluntary caps on overall leverage, investors are still exposed to forced deleveraging in a rapidly falling market.
SEED tries to buy less volatile closed end funds that trade at greater than a 10% discount to their NAVs and look to sell when the funds trade closer to their NAV. We also weigh the fundamental attractiveness of the underlying assets and recent trading behavior of the fund. The opportunity isn’t always there, but history shows that it can be advantageous to provide liquidity in this sector when sellers emerge en mass. We want to emphasize, though, that with the return potential comes real risk via leverage and lack of liquidity. The sector is not a pure substitute for more liquid, more diversified and un-leveraged traditional fixed income alternatives.
For a more detailed overview on the sector, see my article first published in Alpha Architect here.