Discounts & Premiums

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Ideally, there would be no difference between a closed-end fund's share price in the market and its net asset value per share. Thus, there would be no discounts or premiums. However, prices are established by competitive markets which reflect "real world" buying demand and selling supply of shares. In turn, these are influenced by investors' perceptions, fear and needs for specific types of investments. Other factors which have been suggested as having an impact on discounts and premiums include: the fund's relative performance, yield, the use of a managed distribution program (guaranteed annual payout of 8%-10%), name recognition of the fund's manager, a significant amount of illiquid holdings in the fund's portfolio and a sizeable amount of unrealized appreciation.

What do discounts and premiums mean to a typical closed-end fund investor? Perhaps not very much. The price of a closed-end fund usually tracks the fund's NAV; thus, in the long run, the price performance will be similar to the NAV performance of each respective closed-end fund unless there has been a dramatic change in the fund's discount/premium during the specific measurement period.

While discounts persist, investors are able to purchase additional shares in the market and put more than a dollar of net assets to work for every dollar invested. Some brokers urge buying shares when discounts widen, because this makes the shares even more of a bargain.

Some investors think the benefit of buying closed-end fund shares at a discount occurs only at the time of purchase. However, the advantage can continue to reward investors for many years, as shown in the following comparison of two hypothetical funds with identical performance and net asset values of $10 a share (chart below). Fund A is a mutual fund and Fund B is a closed-end fund selling at a 20% discount to NAV ($8 per share).

(A discount of 20% is used in this example to dramatize the impact of the discount over a long period of time and is not meant to be illustrative of typical discount rates.)

A hypothetical investment of $10,000 in Fund A buys 1,000 shares. (Commissions are ignored.) The same hypothetical investment buys 1,250 shares of Fund B at a cost of $10,000. These shares represent net asset value of $12,500.

Let's assume that both funds return identical performance over 20 years, as follows

• A 10% annualized rate of return calculated on NAV, of which 3% is income dividends and 7% is capital gains. Both dividends and gains are calculated based on NAV at the start of each year.

• The income dividends are taken in cash and the capital gains are reinvested into new shares. (Taxes are ignored in this example, as if the investments are held in retirement plans.)

The table below shows the rate of income and cumulative income that an investor would receive in both funds over 20 years. To summarize:

• The dividend yield begins at 3.0% in the first year for Fund A, and at 3.75% for Fund B. It is higher in Fund B because it is calculated based on a larger amount of net assets at work ($12,500 in Fund B vs. $10,000 in Fund A. 3% of $12,500 = $375. The $375 of income dividends divided by an investment of $10,000 = 3.75%).

• The annual income yield of Fund A, the mutual fund, gradually increases to 10.8% of the original investment over 20 years. The total income generated over 20 years is $12,299.

• The annual income yield of Fund B, the closed-end fund, gradually increases to 13.6% of the original investment over 20 years. The total income generated over 20 years is $15,373.

Notice that if an investor sells both funds at the end of 20 years, and the closed-end fund is still at a 20% discount, the investor will realize the same principal in each case. However, over time the investor pockets more than $3,000 of additional current income from the closed-end fund, thanks to the discount.