Usually closed-ended mutual funds trade at discounts to their underlying
asset value. If the price of the fund's assets less liabilities divided by the
outstanding units is $10, the fund might trade on the stock market at $9. This
fund would be said to be trading at a "10% discount to its net asset value".
The reason for this discount is debated by academics, but is largely due to: 1)
the fact that the fund units are not as liquid as the actual underlying
investments and 2) the negative present value of the management fee and fund
administration costs.
 Liquidity Differential
The holder of a unit of a closed-end fund holds the legal title to her pro
rata share of the fund's investments. This is clearly different than holding the
same amount of the underlying securities in two ways. Firstly, if the investor
held the same amount of the underlying securities as in her pro rata share of
the fund, she could liquidate them at market prices to obtain their market value
at any time. However, by holding units of the fund, she must sell actual units
of the fund, which are probably far less liquid than the actual underlying
securities. Secondly, she has to depend on the investment management of the fund
to realize the underlying value for her. If she thinks that a security in the
fund is overvalued, it is not her decision to sell. She must await the judgement
of the investment manager. Although she might not want or need to hold a
particular investment within the fund, since she cannot sell individual
securities herself, she must chose between selling all of her fund units and
staying with the fund.
 Negative Value Of
Management Fees and Administration Costs
The holder of a closed-end mutual fund also has to consider the effect of
the management fee and administration costs on the value of her fund holding.
Since the closed-end fund documents allow these charges to be made against fund
assets for the life of the fund, it presents an ongoing cost to the unitholder
compared to holding the securities directly. If these fees amount to 3% per
year, this means that there is a future stream of expenses built into the actual
value of the fund units. The fund will deduct these expenses from the fund
income or sell holdings to pay the fees as contracted. In financial terms these
expenses or outlays are "negative cashflows" that have a "negative
present value" accounting for the time value of money. As a rough cut, with
a very long term to the life of the fund (a duration of over 10 years) and fees
and expenses of 1% per year would indicate a 10% discount to asset value and a
3% fee would be 30%. This is one figure that underwriters don't feature in their
marketing literature for new issues of closed-ended funds. |