The Strange Behavior of Closed End Funds (CEFs)

Closed End Funds (CEFs) are entities that invest money and trade on stock exchanges. In contrast to “open-ended” funds (OEFs) like mutual funds and conventional exchange-traded funds (ETFs), CEFs are formed and sold with a fixed pool of initial investment capital. I.e., they are designed to not accept further capital after their IPO, and it is nearly impossible for shareholders to redeem shares by asking the CEF to liquidate holdings and buy the shares back. The advantage of this structure is that a CEF can enter long-term contracts and investments that open-ended funds either should not or cannot, because an open-ended fund has to be able to liquidate its positions whenever investors ask for their money back (i.e., when a shareholder “redeems” shares).

One of the curious results of CEFs being “closed” is that they can trade at values significantly different from their NAV. NAV, or Net Asset Value, is the intrinsic/market value of an investment fund’s assets. If a fund sold everything it owned at the current market price, it could redeem its shares at the NAV. As a result, except during extreme market crises when securities can’t be sold in large quantities, open-ended funds always trade very close to their NAV.

CEFs routinely trade at significant discounts and premiums to their NAV. (When the trading price is below the NAV we say the fund is trading at a discount. When the price is above the NAV we say the fund is trading at a premium.) Trading fluctuations away from NAV are not hard to understand: All securities trade away from their fair market value due to liquidity demands. For example, when an owner wants to sell a large amount of shares he is “demanding liquidity.” If he wants to sell more shares more quickly than the market is prepared to purchase, then he will have to reduce the price he asks for the shares to drum up more buyers. I.e., he sells shares at a discount. (This is the same as when stores put things “on sale” or “clearance:” there are always people looking for a bargain.) Conversely, if someone wants to own more of a security than is for sale at the current price, he will have to offer to buy them at a higher price to entice more people to sell. I.e., he buys shares at a premium. Both of these scenarios are characterized as “liquidity demand,” and they both cause changes in the market price of the stock.

Many stocks also fluctuate in price because investors take different or changing views on the true present value of the underlying company. But in the case of CEFs the true present value is not in dispute: CEFs are just collections of securities, all of which have a public market price. So every day we can look at both the value of what the CEF owns (its NAV) and the price at which the CEF itself is trading. We can also look at the ratio of those two numbers to see the premium or discount the market has assigned to the CEF. For example, here is a chart of the daily price and NAV for a CEF from 2017 to the end of 2019. (EOS is the symbol for the trading price, and XEOSX is the NAV. The charts are from CEFconnect.com.)

From this we can see that sometimes this fund trades at a discount to NAV, and sometimes at a premium. But over this period it almost always traded within 6% of its NAV.

Again, we know that such fluctuations in a stock’s premium and discount can be attributed to liquidity demand.

But there is a phenomenon seen in many CEFs that is very strange: CEFs that trade at persistent and large premiums or discounts. Here is a typical example of a fund that trades at a large and persistent discount (ticker AGD):

Over this six-year period this fund traded at an average discount of more than 10%, and never less than 6%. And there are examples that go the other way. The CEF with ticker RCS trades at a large and persistent premium:

Why would a CEF trade at a large and persistent discount to its NAV over a long period of time? That can’t be explained by liquidity demand. After all, if it were liquidated then shareholders would receive NAV. But in the case of this CEF market participants are always buying and selling the fund’s shares at prices that appear to be significantly less than the present value of the thing they are trading. This shouldn’t happen in an efficient market.

Why Markets Are Efficient ... and what you should do about it

It may seem odd for me to declare that "markets are efficient" given that I have spent my career working (successfully) on investment strategies and businesses that "beat the market."

When I say that markets are efficient, I don't mean that I subscribe without qualification to the Efficient Market Hypothesis. Rather, I mean that the average investor should not expect to beat the market.

Financial markets are in fact riddled with inefficiencies.  But the average investor can't exploit those inefficiencies to make money.

Average (Retail) Investors

Almost everyone is an Average Investor.  For the purposes of an Average Investor markets are efficient.  Average Investors can't expect to pick stocks that will outperform the market on a risk-adjusted basis.  They can't expect to outperform markets by timing when they are in or out.

The key word here is expectation.  Simply due to chance it is certainly the case that a particular stock picker or market timer will get lucky and outperform the market.  But for every lucky pick there is an unlucky pick made by another Average Investor.*  So taken as a whole any particular Average Investor will do no better than the average of all investors.  We have a name for the average of all investors: The Market.

Even most professional money managers, including mutual fund managers and investment advisors, are Average Investors.  This fact is so well documented that it bewilders me that there are still money managers charging disproportionate fees for "active management."

So what should you, as an Average Investor, do?  As I have written before: Know your risk tolerance.  Then buy and hold a diversified portfolio of low-cost market index funds that matches your risk tolerance.  Don't try to beat the market.  Just hope to keep up with it.

* There is a broad perception that it is possible to beat the market because the lucky investors tend to loudly advertise their luck – even delusionally attributing their luck to some repeatable skill – whereas unlucky investors are not so prone to tout their misfortune.  Further confusing the perception is the fact that there are businesses that beat the market, which brings us to the next section.

Specialists and Alpha

So what about those inefficiencies I mentioned earlier?  Who gets to take advantage of those to actually "beat the market?"

In the finance industry we refer to investment returns that "beat the market average" as "alpha."  There are all sorts and sources of alpha.  But especially in modern markets they all have one thing in common: They are not accessible to Average Investors.  It takes work to find and harvest alpha.  Alpha capture is a business.  Sometimes alpha businesses are wildly profitable.  (But so are businesses in every other industry.)  In rare cases an individual may stumble onto an overlooked source of alpha and make a vast fortune from it.  (But so do rare tycoons in every other industry.)  For most of us in the alpha business it takes a lot of work to find alpha and build a business to harvest it.

Many sources of alpha fall under the broad term "arbitrage."  In the financial markets arbitrage is strictly the domain of businesses like hedge funds and bank proprietary trading desks, which can bring to bear substantial resources to access and exploit fleeting and statistical inefficiencies.

In broad strokes: alpha businesses make their money exactly because they remove market inefficiencies.  And this is why Average Investors can't beat the financial markets.  Any more than they can hope to make money buying products on Amazon and reselling them from home.  Anyone who wants to make money as a merchant has to invest real time and money into doing so.  If they make a full-time job of it they might be able to earn a living.  But they will do so picking up the crumbs dropped by huge companies (like Amazon) that have more capital, better market access, and vastly cheaper logistical chains than anyone else

There are two noteworthy exceptions to this generalization:

1. The investor with Special Information.  For example: You may work in healthcare, or construction, or some other industry where occasionally a relatively unknown product or company is coming to market.  If you have special information that is better than what the Average Investor can glean – better even than what the investment bank analysts that cover your industry can see – that some company is going to be a breakout success, and you can buy into that company before everyone else can see that; and if your assessment based on your special information is correct, then you can earn excess returns (i.e., alpha) by investing on that.
2. The investor with Special Access.  There are investment opportunities that are just not accessible to the market overall.  For example, only lawyers can own equity in a law firm.  (And only lawyers that are invited by the firm to do so!)  If legal or regulatory restrictions put a general bar on an investment, but you are exempt from that bar, then you can potentially earn better risk-adjusted returns on that investment than you could in the public financial markets.