Closed-End Funds and the Myth of the Discount: What Investors Need to Know

If you’ve ever sat through a pitch on a closed-end fund (CEF), chances are the salesperson led with one selling point: It’s trading at a discount to net asset value (NAV).” It sounds compelling. Why not buy a dollar’s worth of assets for 85 or 90 cents? But as with most things in investing, the reality is more nuanced. A discount to NAV can indeed be an opportunity but it’s not the whole story.

Key Terms to Know

Closed-End Fund (CEF): Unlike mutual funds, which issue and redeem shares directly with investors, closed-end funds issue a fixed number of shares that trade on an exchange like a stock. Buyers and sellers transact with each other, not with the fund manager, so the number of outstanding shares doesn’t change.

Net Asset Value (NAV): NAV is simply the total value of a fund’s holdings divided by the number of shares. For mutual funds, the share price always equals the NAV at the end of each trading day. For CEFs, however, market prices fluctuate throughout the day and often deviate from NAV. Most CEFs trade at a discount to NAV, meaning investors can buy in below the “book value” of the underlying assets. Occasionally, a fund trades at a premium.

Why the Discount Exists

From a textbook perspective, a persistent discount makes little sense. The “Law of One Price” in economics says that identical assets should trade at the same price. Yet, CEFs routinely defy that principle. Why? Scholars and practitioners have debated this for decades. Common explanations include:

• Liquidity: CEFs are less liquid than large mutual funds

• Management Fees: Higher costs reduce appeal

• Manager Skill: Concerns over underperformance

• Leverage: Unlike mutual funds, many CEFs borrow to amplify returns (and risks)

• Asset Mix: CEFs can hold illiquid assets since they don’t face redemption pressure. None of these explanations fully “solve” the so-called closed-end fund puzzle.

Why It Matters for Investors

The real question for investors is whether a discount to NAV can translate into superior returns. The dream scenario, buying a CEF at a steep discount and waiting for the market to “correct” the mispricing, is often unrealistic. Discounts can last for years, even decades.

For example, the GDL Fund (GDL) hasn’t traded at its NAV since 2007. Occasionally, activist investors step in, force a liquidation, and unlock NAV. But that’s rare and not something ordinary investors should count on. As the saying goes: hope is not a strategy.

The Right Way to Think About Discounts

Instead of viewing a discount to NAV as a free lunch, investors should treat it as one factor among many. The more important questions include:

• Management Quality: Has the team delivered consistent results?

• Asset Class Outlook: Is the sector positioned for growth?

• Fees & Leverage: Are costs reasonable and risks manageable?

• Distribution Record: Are payouts sustainable and reliable?

If those fundamentals check out, then a discount, especially one that’s wider than the fund’s historical average, can tip the balance in favor of buying.

Bottom Line

Discounts to NAV are more the rule than the exception in closed-end funds. They are not a signal of free money or a guaranteed arbitrage opportunity. But when coupled with strong management, a favorable market outlook, and disciplined structure, a discount can be an added reason to invest.

In short: don’t chase the discount, evaluate the fund. If the pieces line up, the discount may enhance your upside, but it should never be the only reason you buy.