How Closed-End Funds Should Trade in Theory

An interesting post from Financial Samurai or how closed-end funds trade. A closed-end fund is one that trades on a stock exchange but has a fixed number of shares on a day to day basis.* They may occasionally do additional share issues, or reinvest dividends, or even buy back shares, but they don't buy and sell shares continuously to keep the market price at the net asset value or NAV. ETFs, by contrast, do continually create or redeem new shares to keep the market price close to NAV. I posted a comment about where the equilibrium price of a closed-end fund should be that I thought was worth its own post here.

In theory, if the fund manager grows the NAV of the fund with distributions reinvested faster than the average stock market rate of return (for assets with similar beta), then a closed end fund should trade higher than NAV and vice versa. 

This should be the equilibrium price, so that investors don’t get a free lunch of a higher than average return or conversely a worse than average return. If the average fund manager performs the same as the market before fees then on average after fees managers will under-perform the market and so the typical closed end fund will trade at a discount to NAV.

Of course, actual prices often deviate from this equilibrium for a long time! Pershing Square Holdings, which trades on the LSE, is a classic case. It has either outperformed or matched S&P 500 performance over the last few years while investing mainly in large cap US stocks, but trades at a massive discount to NAV. As an investor, one of my reasons for investing was this large discount. We’ve experienced good returns but not much closing of the discount. In fact the discount today is the same as it was in 2021 when we finished buying our current position. The market price is 25% below NAV! Our internal rate of return has been 20%, which is clearly better than the stock market average. The S&P 500 has returned 15% p.a. over the last ten years or 14% over the last five. So, it is crazy that the discount hasn't at least narrowed.

* Sometimes people refer to unlisted private equity funds that raise a given amount of money and then invest it as closed end funds too.