Closed-End Funds
A closed-end fund (CEF) is an investment company that holds a portfolio of assets (often stocks) and issues a fixed number of its own shares, typically sold in an IPO, that then trade on an exchange like a stock.
- Because the share supply is inelastic and investors trade the fund shares with each other (rather than redeeming with the fund), the CEF’s market price can deviate from its net asset value (NAV), which is the per-share value of the underlying portfolio, given as
- This is contrary to an open-end fund, where the fund manager can issue new shares in order to fix fund share price deviations from the NAV.
- If new investors bring in money, the fund issues new shares at NAV and uses the cash to buy more of the underlying assets. Shares outstanding rises.
- Because creation/redemption happens at NAV, the trading price doesn’t drift far from NAV, in contrast to closed-end funds.
In a frictionless rational benchmark, a CEF should trade at par relative to NAV, but empirically CEFs often trade at discounts (market cap below NAV) that fluctuate over time and tend to converge back to NAV when the fund is terminated.
- More particularly, a CEF trades at a premium of after its inception (CEFs are usually created during times of high investor sentiment), but falls to a discount of within 120 days, and is subject to wide fluctuations thereafter.
- A common behavioral explanation is retail investor sentiment, where shifts in sentiment move the fund price even though the underlying portfolio value is unchanged, which also helps explain why discounts across different CEFs are correlated.
- Fundamental risk of underlying assets and noise-trader risk in the CEF drive its price down to compensate for the additional risk.
If a CEF is shut down (i.e., liquidates its portfolio, pays off its liabilities and returns cash to shareholders, eliminating noise-trader risk) or converted to an OEF, price converges to NAV because shareholders can then effectively receive NAV.