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Closed-End Funds and Panic Selling:

I posted a few days ago about the crazy action in closed-end mutual funds. At the end of the week, the action got even crazier. As of market close on Friday, the median closed-end fund was selling at slightly under a 30% discount to net asset value. In other words, investors could buy $100 worth of securities for just under 70 dollars.

This is simply extraordinary. In normal times, the average discount for a closed-end fund hovers around 5%. In bad times, it may go to 15%. Since the Great Depression, only in the early 80s has it gone above 20%, just before the great bull market that started in 1982.

To give you an example of the discounts that are out there, one single-state municipal bond fund closed at a net asset value of 11.21, with the last trade at $6.69, a 40% discount to net asset value. Earlier in the day, the fund sold for as low as $5.01, meaning that you could have bought $100 worth of underlying assets for less than $45. A few months ago, the fund was selling at a 10% premium to Net Asset Value. If such funds don't regress to something close to their historic mean discounts, investors will inevitably demand (with varying degrees of success) that the funds liquidate and distribute the proceeds to their shareholders--a fund selling at a 40% discount can return greater than 60% to shareholders by open-ending.

While municipal bond funds carry some risks that their underlying net asset value is misreported, and also some risk relating to the leverage they employ, even plain vanilla conservative stock funds are selling at historically high discounts of 25% or more. At least one fund that invests mainly in treasury bills and cash is selling at a close to 30% discount.

Unlikely other publicly traded securities, closed-end funds are primarily an investment vehicle of individual investors. Other such vehicles, such as master limited partnerships and Canadian energy trusts, are also getting absolutely hammered with little regard for fundamentals.

This all suggests to me that we are truly in a state of panic-selling, and, of course, that many closed-end funds are currently a bargain relative to purchasing the underlying securities. Panic-selling usually denotes the opposite of the buying frenzy at the end of a bubble market, that is, that a bear market is ending. But given the instability we have seen in the markets of late, I wouldn't bet the house on it.

UPDATE: CEF's that were trading at huge discounts Friday afternoon are almost universally up 10% or more with today's rally.

UPDATE AFTER MARKET CLOSE: Closed end funds soared today, as did the MLPs and energy trusts mentioned above. The single-state mutual fund I mentioned above was up 30% today.

Related Posts (on one page):

  1. Closed-End Funds Update:
  2. Closed-End Funds and Panic Selling:
  3. Crazy Action in Closed-End Mutual Funds:
MS (mail):

I wouldn't bet the house on it.


Well done.

Do you know how much time it might take these funds to liquidate and distribute the proceeds (and whether liquidation could be done without further depressing the asset values)? If it takes any significant amount of time, wouldn't these discounts effectively represent a futures market for the underlying assets?
10.13.2008 1:57am
DangerMouse:
As of market close on Friday, the median closed-end fund was selling at slightly under a 30% discount to net asset value. In other words, investors could buy $100 worth of securities for just under 70 cents.

You do realize that a person who purchases a closed-end fund will never realize any economic advantage to the fund's net asset value unless the discount disappears, which is almost never the case? A fund trading at a discount would have to undergo some radical news or a wholescale transformation to put its market price at a premium to net asset value. Unless the Fund is in the position of reality re-purchasing its shares, an investor should treat the market price as the price of his shares instead of the NAV.

The only reason anyone is ever interested in the discount between NAV and market price are hedge funds looking to liquidate the fund, get bought out by the fund, or open-end the fund. Only people who rattle the cages of the Board get that treatment. Mom and Pop investor do not.
10.13.2008 2:04am
James Gibson (mail):
In other words, investors could buy $100 worth of securities for just under 70 cents.

EIther my math is failing me or you either meant they could buy $100 worth of securities for $70 dollars or $1.00 worth of securities for 70 cents. That if your 30% discount is what I think you mean.
10.13.2008 2:46am
MS (mail):
Dangermouse,

I think Dave's point is that the cost of a hedge fund's moving in, forcing a liquidation, and resolving the inefficiency represents a floor on the discount to NAV, which presumably is above 30% freaking percent. Of course, if there is a risk that stocks will fall further before they can accomplish this (combined with the cost of credit these days) then that might explain the numbers.
10.13.2008 2:47am
neurodoc:
I think Dave's point is that the cost of a hedge fund's moving in, forcing a liquidation, and resolving the inefficiency represents a floor on the discount to NAV, which presumably is above 30% freaking percent. Of course, if there is a risk that stocks will fall further before they can accomplish this (combined with the cost of credit these days) then that might explain the numbers.
If one could short the same securities held by the same close end fund, wouldn't that be protection against loss from a fall in value of those securities?

What does it take to pick up a figurative hammer and break open one of these figurative piggy banks to have what is held within them at a price less than what one would have paid for the contents alone? What stands in the way? Who profits from keeping the piggy bank intact when the liquidated value would be greater than the purchase price? Have often does it happen that the discount becomes so great that a fund is liquidated?
10.13.2008 3:05am
American Psikhushka (mail):
David Bernstein-

In normal times, the average discount for a closed-end fund hovers around 5%. In bad times, it may go to 15%.

Maybe on average for all closed-end funds including municipal bond funds. But I've been following them for a good 7+ years and one can usually find a good 50-100 funds trading at a 10-15% discount, mainly stock funds. There are actually more funds trading at higher discounts out there than your statement implies.
10.13.2008 4:13am
American Psikhushka (mail):
Danger Mouse-

You do realize that a person who purchases a closed-end fund will never realize any economic advantage to the fund's net asset value unless the discount disappears, which is almost never the case?

Actually the market price often does move from discount to parity to premium and back again, just through regular market gyrations. Of course you have to make sure you're not buying a fund that holds overpriced or risky junk, but you have to make sure you're paying a good price for any investment.

The only reason anyone is ever interested in the discount between NAV and market price are hedge funds looking to liquidate the fund, get bought out by the fund, or open-end the fund. Only people who rattle the cages of the Board get that treatment. Mom and Pop investor do not.

Not so. True, there is more profit in being a control investor. But if the assets held by a fund are fairly or under-valued and the fund is trading at a discount there may be extra value there.
10.13.2008 4:22am
Obvious (mail):
DB: "I wouldn't bet the house on it."

Wouldn't that depend on how much equity you have in it...?
10.13.2008 5:31am
paul lukasiak (mail):
Part of the problem is probably a lack of understanding of what these funds represent -- and its a lack of understanding that I share.

For instance, who owns the "Morgan Stanley European Growth Fund?", i.e. if Morgan Stanley goes belly up, are the stocks in that fund Morgan Stanley assets that can be liquidated to pay off other obligations, or is the fund merely administered by Morgan Stanley, and the people who have money invested in those funds continue to own the stocks held by them?

If the former is the case (i.e. the funds are owned by the company) then huge discounts on those funds make perfect sense -- the loss of confidence in fund managers and the institutions they work for is quite rational, given recent events.

A note on municipal bond funds --- given that most municipalities primary source of revenue is real estate taxes, and that receipts from those taxes is about to take a nosedive, the potential for widescale defaults on municipal bonds is probably at an all time high. So I'm not so sure that the "market" is wrong about its pricing of those bonds.
10.13.2008 9:02am
DavidBernstein (mail):
Paul, the oddity is that muni bond prices are down about 15-20%, but some closed-end funds' prices are down up to an additional 50% on top of that. I doubt that small fry CEF investors are that much more cognizant of budgetary problems than the institutions that buy the bonds and set the price.
10.13.2008 10:25am
paul lukasiak (mail):
thanks for the clarification David.

You say that "some" of the closed end muni funds are down an additional 50%. Is it possible that these are funds that invested in more "high-risk" munis? (I mean, if I was in a muni fund that was heavily invested in Detroit, I'd want out...)
10.13.2008 12:17pm
American Psikhushka (mail):
paul lukasiak-

For instance, who owns the "Morgan Stanley European Growth Fund?", i.e. if Morgan Stanley goes belly up, are the stocks in that fund Morgan Stanley assets that can be liquidated to pay off other obligations, or is the fund merely administered by Morgan Stanley, and the people who have money invested in those funds continue to own the stocks held by them?

Closed-end funds are just a portfolio of securities that they sell shares of on the market. In the example you mentioned the fund is managed and administered by Morgan Stanley, but the portfolio is owned by the shareholders just like a publicly traded company.
10.13.2008 12:36pm
paul lukasiak (mail):
Thanx AP. I actually called up my Morgan Stanley "financial advisor" and asked, and got the same answer.
10.13.2008 1:47pm
Joel Hass:
Discounts on closed end funds are good for investors even if they never disappear. They magnify dividend yields. A 10% yield on the underlying securities doubles with a 50% discount.
10.13.2008 2:48pm
DavidBernstein (mail):
Paul, the one I was thinking of was a Pa. muni fund, no particular hardships, had been at a 10% premium, closed Friday at a 40% discount, up 30% or so today.
10.13.2008 2:58pm