What to do about premium-priced closed-end funds

What to do about premium-priced closed-end funds

What to do about premium-priced closed-end funds

It’s perfectly reasonable for investors to expect that mutual funds have around the same price as their underlying securities. But new investors in closed-end funds might find a surprising 20% to 80% premium over their net asset value.

“Unlike the more common open-end funds, closed-end funds issue a set number of shares that are traded on an exchange,” explained a recent report from The Wall Street Journal. “They often trade at a premium or discount to the value of their holdings, because the number of shares can’t fluctuate with demand.”

Certain closed-end funds would tend to go through months-long periods of persistence in premium share prices. Citing Ryan Paylor, a portfolio manager with Thomas J. Herzfeld Advisors in Florida, the Journal said that such high-premium funds are held mainly by individual investors who may not be as sensitive to nuances in mutual funds as sophisticated institutional investors. Because of this lack of awareness, they don’t sell even when funds are trading at anomalously large premiums.

Then there’s the fact that most premium-priced funds make large regular distributions, creating an eye-catching opportunity for yield-chasing income investors. Distributions to dividend-reinvestment programs that occur at the net asset value rather than the fund price can also sweeten the pot further.

“Fourth, these funds usually have little competition in their investment category,” the Journal noted. It added that leverage, taxability, the liquidity of a fund’s holdings, stale NAVs, and lending fees holders may charge short sellers could also prop up premiums.

A substantial fall in a closed-end fund’s price premiums generally only comes after a distribution cut, observed Boston College finance professor Jeffrey Pontiff. Such cuts typically happen because past payouts have included capital as well as earnings.

Some investors, realizing that a fund’s share prices are bloated relative to its holdings, might consider shorting it in anticipation of a decline or total evaporation of the premium. But those adopting that strategy should be prepared for a Pyrrhic victory, cautioned Brett Owens, chief investment strategist at the CEF Insider.

“[P]remiums can last a long time, and the fees to borrow the shares can eat into any profits from this tactic,” the Journal explained, citing Owens. Profits can also be blunted by the short seller’s obligation to pay any fund distributions out-of-pocket to the share lender.

Long bets on a high-premium closed-end fund — where one buys it at a certain share price and sells it even higher — might work out. But Owens counsels income investors to play the probabilities.

“[T]he odds favor the conventional wisdom: Never buy a CEF trading at a premium,” he told the Journal.

 

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