Stay Away from Some Closed-end Funds
Ever wonder why some closed-end funds trade at a discount to their net asset value? After all, closed-end funds hold baskets of stocks, bonds and other investments, each of which have a certain value. The total value of the assets in a closed end fund should equal the closed-end fund share price times the total number of shares outstanding, right? Wrong. Investors seem to believe that once certain assets are grouped together, the sum of assets becomes different than the parts.
Investment guru Burton Malkiel decided to find out why investors believe this. The Princeton University professor studied 30 closed-end funds and found that, on average, they were trading at a six percent discount to their net asset value, or what the assets actually are worth.
Within the group, the professor found that "funds selling at the largest discounts from net asset value tend to have the largest amount of unrealized appreciation and the biggest share of their assets invested in restricted stock."
By unrealized appreciation, the professor means assets that have gained a lot in value but have not been marked up for accounting purposes. Restricted stock refers to stock that is not readily bought or sold, for example, stock issued by small start-up companies or stock held by a family, which is not often traded.
The professor also found that "high turnover has the effect of increasing the premium on fund shares (or reducing the discount)" and that the more a closed-end fund is owned by insiders, the more its stock price will trade at a discount. But the evidence for these findings was relatively weak.
Professor Malkiel believes that, for some reason, investors undervalue restricted securities in closed-end funds, arguing that when accountants value the securities for the funds, they are quite conservative.
Bottom line: look at the holdings of closed-end funds you are considering buying. Avoid closed-end funds that have a high level of restricted securities and unrealized capital appreciation in their portfolio.
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