Is It Worth A Dollar If You Can't Sell It For A Dollar? (Investment Planning)

Over the past couple weeks, the average investor is getting an important lesson on the difference between “asset value”, and “market value”, courtesy of Mr. Market.

For years folks have known that one buys an open-ended mutual fund at its “net asset value” or “NAV”. The minor downside to this approach is that you essentially can only buy a mutual fund at the end-of-day price. The upside to this approach is that mutual funds are required to tally up their assets at market value at the end of each day and divide the value by the shares outstanding, with adjustments for shares bought and sold that day. Clean and transparent.
“Closed-End Funds”, or “CEFs”, operate differently. Quite often, they offer investors instant diversification among multiple investments, usually in a single asset class (say, U.S. preferred stocks). These funds trade intraday in the market – there is typically a bid price where one can sell, and an offer price at which one can buy. But the CEF is notclosing up shop each day and matching the portfolio value to the market value of the investments. This can result in a CEF trading at a premium or discount to its net asset value. Often this premium or discount can depend on the ease with which the underlying securities can be traded.
Let’s say we open a closed-end fund that invests in the members of the Dow Jones Industrial Average that start with the letter “C”: Caterpillar, Chevron, Cisco and Coca-Cola. For sake of simplicity, if our CEF owned just one share of each stock, today it would be worth roughly $266 in total. If there are ten shares of our CEF outstanding, each share is worth $26.60. What would keep our CEF from trading down to $10.00 per share today (assuming the underlying stocks stay where they are)? Answer: the fact that somebody could then buy our CEF and then sell short (borrow and sell) the stocks in the CEF – and lock in a potentially riskless profit. That “arbitrage” is what keeps some CEFs from trading at a large premium or discount.
But now what if the CEF you own invests in securities that are not as liquid as large U.S. stocks. (Does this sound like a municipal bond CEF you may own?) The less liquid the underlying securities, the greater the potential for the CEF to trade at a large discount or premium.
Beware of opportunities to buy a CEF at “a 20% discount”… sure, people like to buy things at a discount. But there may be little stopping Mr. Market from pricing that CEF at a 30% discount when yougo to sellit. And often times, you may find yourself looking for opportunities to sell when others are panicking to do the same.
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