Discovering Value with Discounted CEFs

Across most asset classes, current closed-end fund discounts appear wide relative to short- and long-term averages. This may present an opportunity for long-term investors. Closed-end funds purchased at discounts wider than their historical average have the potential to reward investors with a higher market distribution rate, as well as higher returns over time, should the discount narrow. Learn more below and   explore opportunities.

Why purchase discounted CEFs?

Many investors look to closed-end funds (CEFs) for portfolio diversification and the potential for higher income. CEFs feature structural advantages over many open-ended funds, including the ability to invest in less liquid corners of the market, stay more fully invested instead of holding aside cash or liquid investments to meet redemptions, as well as the capacity to use leverage with the goal of enhancing income and returns. An additional attractive feature of investing in CEFs is the ability to purchase shares at a discount to net asset value (NAV). In other fund structures, such as mutual funds or ETFs, shares are typically purchased at, or very close to, NAV.

Purchasing shares of a closed-end fund trading at a discount can be advantageous for a number of reasons. Shares purchased at a discount can potentially reward an investor with higher capital appreciation should the discount to NAV narrow over time. In addition, shares bought at a discount to NAV may have a higher distribution rate on market price, as each dollar invested receives earnings from more than a dollar’s worth of assets.

CEFs are currently trading at historically wide discounts

Closed-end funds frequently trade below, or occasionally above their NAV (Figure 1). While many theories try to explain this occurrence, closed-end fund market prices are largely determined by supply and demand. Discounts, or premiums, are the result of a number of factors such as market and investor sentiment, fund performance, as well as certain quantitative and qualitative factors relating to the fund. For example, distribution rates play a significant role in a fund’s relative valuation. Funds with an above average distribution rate may trade at a premium to the fund’s NAV and/or a narrower discount to the peer group. Conversely, funds with a lower distribution rate, or funds whose future earnings or distribution potential is limited or declining, may trade at a wider discount than similar funds.

In weaker or more volatile markets, or at times of uncertainty, discounts can widen significantly. For example, closed-end fund discounts widened across the board over the course of 2022, against a backdrop of weaker equity and fixed income markets, elevated volatility, and concerns over higher leverage costs and their impact on fund distributions. Year-to-date through August 31, 2023, most CEFs asset classes have seen their discounts widen further, albeit steadily. Looking at longer-term data, current discounts within most CEF asset classes are now wider than their averages over 1-, 5-, 10- and even 20-year periods (Figure 2).

How to evaluate discounted CEFs

Although wider average discounts among the asset classes above appear compelling and point to potential opportunities for higher income and total return over the longer term, discounts can vary significantly between funds in each asset class. In addition to considering absolute discounts, investors should examine an individual fund’s discount relative to its historical range, as a fund’s market price may not always revert to its NAV. A useful metric to help analyze relative value in closed-end funds is the z-score. 

The z-score measures the distance (in standard deviations) of the fund’s current discount from its average discount over a given time period. A negative z-score indicates the fund’s current discount (or premium) is lower than its average. Conversely, a positive z-score indicates the fund’s current discount (or premium) is higher than its average. The magnitude of the z-score is key. For example, a fund with a 1-year z-score of -2 indicates the fund is trading 2 standard deviations wider than its 1-year average discount. The more negative the z-score, the wider the fund is trading relative to its average over a given time frame. By measuring a fund’s relative value, the z-score can help add context to a fund’s current discount or premium. The table below shows the Nuveen closed-end funds with the lowest 1-year z-scores across national tax-exempt and taxable strategies, as of August 31, 2023.

Although z-scores can be helpful in identifying attractive entry points for individual funds, there can be no guarantee of positive returns for investors, even if discounts move closer to their mean or indeed NAV. Ultimately, investors should take into account many factors when considering buying closed-end funds, such as risk tolerance, individual investment objectives and the outlook for the asset class in question. Z-scores can be useful in helping investors narrow down a selection of funds for further research, and should be used alongside other metrics in evaluating the merits of a particular closed-end fund. Investors can use CEFConnect.com, a website that houses a host of useful metrics related to all CEFs, to analyze 3-month, 6-month and 1-year z-scores.

To discover additional opportunities, explore all closed-end funds.