Since almost all closed-end funds tend to sell at a discount, it can appear obvious that there is no reason to purchase closed-end funds when they are selling at a premium. Sometimes a special feature, for example, a closed-end fund having a private placement in its portfolio which is about to go public as a hot issue, may justify purchase at a premium. Otherwise, it is difficult to make a case for paying a price higher than NAV.

Central to the advantages of closed-end funds is the discount; both as to dividends and as to pricing variances.

Relative to dividends, purchasing a fund selling at a wide discount effectively provides leverage at no cost. This is especially important in bond funds and funds specializing in high-yielding stocks. Let’s say the fund is purchased when it is selling at a 20-percent discount. The investor is effectively paying 80 cents for each $1 of assets. As a consequence, the investor is receiving dividends from $1 worth of investments, having paid only 80 cents.

FundsThe amount of the discount can vary dramatically with the greatest changes usually occurring during extreme market conditions. In depressed markets, discounts in the double digits are common. When investors become overly optimistic, discounts can be significantly reduced or even change to premiums. By properly incorporating market timing, closed-end funds can significantly outperform their open-end counterparts.

For example, let’s say the NAV of both a closed-end fund and an open-end fund is $10, and the dominant sentiment is that the market stinks. Because of prevailing pessimism, the closed-end fund is selling at a 20-percent discount, a market price of $8. The open-end fund would be selling at its NAV of $10.

Now let’s say that the market advances 10 percent and optimism returns. The NAV of both the open- and closed-end fund has appreciated to $11. As is usually the case then, investors become optimistic because of elevated prices. Let’s say the discount on the closed-end fund has narrowed: in our example from 20 to 10 percent.

The price gain on the open-end fund has been $1 ($10 to $11, the 10 percent increase in NAV). The price gain of the closed-end fund is 17A3 (from 8 to 97/8, a combination of both the change in NAV and the narrowed discount). The change in NAV for the open- and closed-end fund has been equal, but the closed-end fund’s share price has gained 23 percent while the open-end shares appreciated 10 percent. The closed-end fund more than doubled the return available from the open-end fund.

Of course, if the closed-end fund was purchased in an untimely fashion, the closed-end fund would perform worse (perhaps dramatically) than the comparable open-end fund.

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