In determining which specific closed-end fund provides the best buying opportunity, it might appear that the process is exceptionally simple: Just see which one is selling at the widest discount and buy it.

Unfortunately, the process is a bit more complicated. As previously discussed, there are valid reasons for discounts. There is also a wide variety of fund types: equity (stocks in general or in industrial sectors), bonds (different types, such as municipal, corporate, foreign, or U.S. government; all with varying maturities), convertible bonds (combining both bond and stock characteristics), specialty (confining interest to a specific country, a very narrow industry sector, venture capital, or specific private placements), dual-purpose (where the fund seeks both capital gains and income), or anything else that can generate public interest and enough sales to capitalize the fund.

FundsOne way to simplify the process of deciding which funds to buy is to determine an “average” premium/discount over an extended period and then determine the degree of discounting at any given time by comparing the current discount to the average discount.

For example, let’s say we are looking at two funds. Fund A is selling at a 10-percent discount and its average discount is also 10 percent. Fund B is selling at an 8-percent discount, but its average is 4 percent. The gross discount of Fund A is greater than Fund B (10 percent versus 8 percent). Fund B, however, would represent the better purchase based on its past because it is 4 percent below its average discount, while Fund A is not below the past average discount. All other factors being equal, Fund B would be preferable because normalization to the average discount would involve capital appreciation, whereas Fund A is already normalized to its past average.

The length of time utilized to determine the average past discount depends on investor preference. We use a rather lengthy time period (usually four years for funds that have been in existence that long), using discounts on a weekly basis. That is, the discount at the end of each week for the past 208 weeks is added up and then divided by 208, thereby deriving the average. When the next week’s discount is added, the oldest past week is subtracted, as in any other moving average.

The average discount calculation need not be as lengthy as the one we use. Yet an extended period is generally helpful because many funds come to market when there is a speculative binge and the fund’s structure (investment types) appeals to emotionalism. This effect was clearly evident during the rage in the late 1980s for single-country funds. Once sold to the public, the funds often traded at very high premiums before settling to discounts. Using a short time period to determine the average discount could give the initial impression that these funds would always sell at a premium when, in fact, after they were “seasoned,” the premiums went poof.

We have attempted to provide only a very general outline of closed-end fund characteristics, just enough to apply our analytical techniques to closed-end funds.

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Measuring Discounts/Premiums