A primary reason for discounts is a lack of sponsorship. If a securities salesperson (dependent on commissions) has a choice of selling someone an existing closed-end fund (say at a regular stock commission of around 1 percent) or a load mutual fund with a sales charge (that can be as much as 8 percent), the incentive is to direct “investors” to the open-end fund.

The incentives associated with higher sales charges can be easily observed when new closed-end funds are issued. In new issues, compensation is by underwriting fees. A typical fee is 7 to 8 percent. If a fund was coming public at $10 per share, an 8-percent underwriting fee would be 80 cents per share.

FundsThe buyer does not see a commission and the naive might think that, by buying a new issue, a transaction cost is being avoided. The cost in our example (8 percent) is far higher than a standard commission on a stock trade. Although the buyer is paying $10 per share, the new closed-end fund is only being capitalized at $9.20 per share after paying the underwriter’s fee. The net asset value is $9.20. In effect, the buyer is paying a premium from the onset.

As previously discussed, almost all closed-end funds eventually trade at a discount to NAV. From this, it is easy to conclude that the buyer in our example has incurred the risks involved in paying a premium for an investment that is likely destined to develop a discount. This conclusion is absolutely correct. Yet the securities industry was not deterred from selling billions of dollars of new closed-end funds in the 1980s at the same time that established closed-end funds could be purchased at substantial discounts.

Discounts can occur for reasons other than a lack of sponsorship: poor yield, subpar performance, a heavy supply of competitive issues, high expense ratios, illiquid portfolios, and potential capital gains tax liabilities. Of course, all these negative factors also affect open-end funds, which will trade at NAV despite inefficiencies.

Note that some closed-end funds can be converted to open-end funds. In these instances, if the closed-end fund is selling at a discount, the price will appreciate to the NAV at the time of conversion.

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