Closed-End Funds: Short-Term Factors Affecting Discount/Premium
Description
This article is from the A Guide to Closed-End Funds (CEFs).
Closed-End Funds: Short-Term Factors Affecting Discount/Premium
Though some or all of the above factors may hold for a particular CEF, it will not always trade at a fixed discount or premium, but, more often, will fluctuate around the level. The amount and frequency of such fluctuations will vary with CEFs depending on a variety of factors including its liquidity, market sentiment, and so forth.
- News.
- Economic, social or political developments may significantly impact the short-term outlook for the markets in which the CEF invests, and, consequently, may affect the price investors are willing to pay for shares of the fund. This is especially true for emerging markets which are traditionally more volatile and sensitive to such developments. For example, the the First Israel fund moved dramatically from a deep discount to a sharp premium with the peace developments between Israel and its Arab neighbors.
- General Market Sentiment.
- The overall market sentiment plays a very significant role in the premium/discount of CEFs. When investors are particularly bullish, as was the case with many of the emerging markets towards the end of 1993 and early 1994, the CEFs investing in these markets traded at sharp premiums, many in excess of 30% premiums. Similarly, when investors are particularly bearish, as was the case in March and April of 1994, many of the same funds traded at wide discounts, often in excess of 20%.
- Excess Supply.
- The introduction of new funds investing in the same markets tends to increase discounts since these new funds draw away money that would otherwise have been committed to the older funds. For example, the introduction of three new funds focusing on India led to a sharp drop in the premium of the older India Growth fund, and eventually to large discounts on the new funds.
- Rights Offerings, Secondary Offerings, or Distributions.
- Of late, many CEFs have resorted to rights offerings to draw additional money into their coffers. Secondary offerings are less frequent, and typically are used by CEFs trading at a premium. Many CEFs encourage investors to re-invest dividend and capital gains distributions through attractive dividend reinvestment plans. All three tend to introduce short-term volatility and sharp fluctuations in discount/premium as investors factor them into the price. For example, secondary offerings are usually priced lower than the current market price to attract investors. Since shares are available at lower prices, the premium drops. Often, it takes a while for the premium to recover, if it does, since most investors wishing to invest would have done so during the offering. For examples of how large distributions or rights offering affect the fund's discount/premium, take a look at the the Austria fund and the Scudder New Asia fund.
- Open-Ending or Takeover.
- Funds that trade at excessive discounts and/or have an attractive portfolio may be the subject of takeovers or open-ending proposals. Some investors may buy a large block of shares and attempt to open-end (or liquidate) the fund, thereby, profiting from the disappearance of the discount. Depending on how the market views the proposals, the discount may shrink or disappear.
- Year-end Tax Selling.
- Many CEFs, especially those that suffered heavy losses during the year, tend to trade at wide discounts during December as investors sell them to realize their losses to offset other gains. Many of them will bounce back to their usual discount/premium level when the tax-related selling abates.
- Sharp Drop in NAV.
- Sometimes, the market price lags the NAV. This is especially true when the NAV drops suddenly and sharply. In such cases, the CEF tends to trade at a premium for some time, possibly because investors expect a market rebound and are reluctant to sell. Examples include the Turkish Investment Fund (early 1994) when the Turkish market crumbled under currency turmoil. The NAV slumped from a little over $14 to a little under $4 in a period of a few weeks. The market price however held its ground better, but at premiums of as high as 100%. Similarly, the sudden devaluation of the Mexican peso in December 1994, led to drops of 40% in the NAVs of the Mexico-related funds (e.g., the Mexico Equity & Income Fund). However, the market price held up better, but again, the funds traded at sharp premiums to the NAV (30%+) when they traditionaly trade at moderate discounts.
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