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  Art Lipson interview in Thomas J. Herzfeld Advisors: The Investor’s Guide to Closed-End Funds (June 2010)
  Putnam Funds: Example of Benefits of Share Repurchases at a Discount
  Closed-end funds and the problem of deep discounts
  Other closed-end fund commentators
   
 
Basics of closed-end funds
   
The problem with persistent, deep discounts
   
What shareholders can do

   


Basics of closed-end funds

A closed-end fund is a type of investment company whose shares trade on a stock exchange or over-the-counter. The assets of a closed-end fund are managed by an asset management firm according to the fund's investment objective and policies, and may be invested in stocks, bonds, and derivative securities.  Just as for standard equity securities, shareholders have the right to vote for a board of directors whose job is to ensure that the fund is run in the best interests of the shareholders.

Unlike conventional open-end funds, the market price per share of a closed-end fund can vary from the value of the underlying asset value per share.  If the market price is below the asset value, then the fund is “trading at a discount.” If the market price is above the asset value, then the fund is “trading at a premium.”  The amount of the discount or premium is measured as a percent of the asset value.  For example, a 10% discount means that investors will receive 10% less for selling the fund than the actual asset value.


The problem with persistent, deep discounts

When a closed-end fund trades at a discount, the marketplace values the underlying assets of the fund at less than their actual value.  Several factors can lead to modest or temporary discounts such as overall market sentiment and general supply/demand imbalances.  These temporary or small imbalances should not necessarily be troubling to closed-end fund shareholders.

However, certain closed-end funds trade at deep (>10%) discounts for extended time periods.  Although various factors can explain this phenomenon, such discounts are often caused by negative shareholder sentiment resulting from factors such as poor long-term fund performance, high management fees, high portfolio manager turnover, poor corporate governance, unsatisfactory shareholder communication, little trading liquidity in the fund, and low secondary market support by the fund’s management firm. 

When discounts remain deep for an indefinite period, shareholders end up being in some sense perpetually “underpaid” for their shares.  If shareholders need to sell for whatever reason, they will not receive the asset value of their shares, but rather will receive the asset value minus the discount.  If the discount permanently remains large, then the discount amount becomes “lost” to the investor, as he or she never gets the opportunity to sell shares in the fund for what the underlying assets are worth.

In addition to lost shareholder value, another problem with persistent, deep discounts is that they often reflect failed policies by the asset management firm.  In other words, these discounts can be a symptom of greater problems at the fund, just as we have alluded to previously.  For these reasons, we view persistent and deep discounts as a problem that management and, as we discuss next, shareholders need to address.


What shareholders can do

A fund’s management firm and board of directors together have a variety of policies that they can implement to reduce a fund’s discount.  Improving management performance, reducing management fees, strengthening corporate governance, increasing communication with shareholders, and other pro-active measures such as large tender offers and share buybacks can all help to reduce the discount and improve overall fund performance.

Unfortunately, management often has little incentive on its own to remove a fund’s discount.  Management is normally paid the same fees regardless of whether its fund trades at a deep discount or at a premium --- the discount does not directly hurt them.  The fund’s board may not fix the problem either, since the board of directors may include persons who may lack professional investment management experience and/or who have a history of backing the management firm (e.g., voting to retain the management firm as the fund’s manager and approving the advisory fees the management firm receives from the fund.)

Since shareholders are the persons most likely to be harmed by a deep discount, shareholders are the ones who need to encourage the fund to reduce the discount and improve overall fund performance.  When shareholders perceive a problem, they should provide constructive feedback to the fund.  Feedback can range from calls to investor relations to letters to the board of directors to withholding votes from management-sponsored board members.  If the fund continues to ignore such feedback, then shareholders should consider taking steps such as nominating and voting for new board members who are willing to work in the shareholder’s best interest.

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