COLUMN-Don’t confuse discounts to NAV with bargains: Fridson

By Marty Fridson

April 1 - Closed-end funds trading for less than the value of their underlying holdings are frequently identified as market inefficiencies, offering investors the opportunity to snap up bargains created by short-term supply/demand aberrations. However, a cursory dip into the data dispels any notion that discounts to net asset value (NAV) represent easy pickings for those seeking superior returns.

One might expect that a closed-end fund (CEF) – an investment vehicle that raises capital by issuing a specific number of shares – should trade at roughly the same value as the assets it holds. That is why financial pundits offering advice on CEFs often point to a discount to NAV as a clear “buy” signal.

Let us suppose that discounts to NAV truly represent temporary anomalies that investors can count on the market to correct before long. We should then expect to find the most deeply discounted CEFs – by this logic, the most underpriced – among the group’s best performers for the succeeding 12 months.

Following the same reasoning, investors would certainly not want to buy a CEF trading at a premium to NAV, as that would mean paying more than the aggregate price required to create the fund’s portfolio on one’s own.

However, the performance in 2024 of some of the largest actively traded U.S. CEFS throws cold water on all those assumptions.

DISCOUNT VS. PREMIUM

I compiled a list of the 30 biggest CEFs by market capitalization, according to Stock Analysis, and I found that the fund that began the year with the largest premium to NAV posted a 19.9% total return. That exceeded the 16.6% return generated by the S-Network Composite Closed-End Fund Index for the same year.

How about the CEF that began 2024 with the steepest discount, which should have been the best buy within the group? It merely matched the 19.9% total return of the fund that started with the biggest premium.

If buyers found that disappointing, they could at least console themselves that they did not buy one of the nine discount-to-NAV funds that underperformed the index, with total returns as low as 2.4%. By contrast, the worst total return for a premium-to-NAV fund in the sample was 17.2%.

A simplistic strategy of buying the 15 funds initially trading at the biggest discounts to NAV would therefore clearly have backfired. The CEFs with prices ranging from 17.6% to -9.2% of NAV delivered an average return of 23.9%. Those with prices ranging from -12.6% to -20.2% of NAV returned just 19.7%.

While the large standard deviations within my modestly sized samples make it impossible to assign any statistical significance to the differences between the average returns, it is nevertheless clear that these CEFs’ performance depended on much more than their beginning-of-period valuations vis-à-vis their NAVs.

Discount devotees might downplay the outcomes reported here, saying that perhaps 2024’s returns were anomalous. Certainly, relative return relationships can vary from year to year. At the very least, however, last year’s results demonstrate that picking CEFs solely on the basis of NAV discounts is not a perennially successful strategy.

NO MAGICAL SHORTCUT

A CEF’s price relative to its NAV is certainly one data point to consider when assessing a fund’s investment merits. But it is not a magical shortcut that justifies skipping all of the other analytical steps necessary when sizing up any type of security.

While temporary market inefficiencies may explain a portion of a fund’s discount to NAV, so may terrible management over an extended period. And if the managers who delivered awful performance are still in place, then it is highly likely that the CEF’s underperformance will continue.

To be sure, it is always possible that an activist manager will ride to the rescue, gain control of the fund, liquidate it, and give investors who bought at deep discounts far more than what they paid per share. However, that did not happen in 2024 to any of the discounted CEFs in my sample, suggesting that it is unwise for investors to count on being bailed out in that fashion.

Ultimately, one can reasonably argue that financial markets are not perfectly efficient, but it is not valid to assert that exploitable inefficiencies are as abundant – or as highly visible – as CEFs trading at a discount to NAV. So investors should get back to analyzing fundamentals and leave the rules of thumb to the financial pundits.

(The views expressed here are those of Marty Fridson, the founder of FridsonVision High Yield Strategy. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors, and Special Assistant to the Director for Deferred Compensation, Office of Management and the Budget, The City of New York).