Closed-End Funds Selling at Discounts Offer Bonus Returns

Wednesday, April 21, 2010

Last month, I wrote, “Closed-End Funds – Structure and Price Discount Add to Potential Returns” (March 12), in which I described the benefit of the closed-end structure for portfolio managers and investors. Today, I want to explain why funds selling at a discount represent more than an opportunity to make an added gain if the discount narrows.

When you buy a closed-end fund at a discount, the price is less than the net asset value (NAV), so you get added assets working for you. This is like leverage, only without the risk and cost of borrowing. Consider it a bonus.

For example, buying a closed-end fund at a 10% discount gives you the earning power of $10 in closed-end fund assets for every $9 you invest. Here are the bonus returns:

  1. You earn a bonus return from income payments. If a fund’s $10 NAV earns net income of 3%, shareholders receive $0.30. Because the price was $9, the return is 3.33%, or a bonus return of 0.33%
  2. You earn a bonus return from capital gains payments. Assume the fund’s NAV rises to $11, then there is a $1 capital gains payment. The fund’s return is 10% based on the original $10 NAV. However, for the closed-end fund shareholder, the payment is 11.11% of the $9 invested, or a bonus return of 1.11%

If these payments are reinvested at a discount, the bonus returns even compound over time.

So… Closed-end funds bought at a discount can provide bonus returns, even if the discount does not narrow.

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