When I went to business school a few years ago (OK, maybe it was more than a few years ago) I remember my finance professor telling the class that it was a mystery why closed end mutual funds traded at a discount. Presumably he was tapped into all the latest academic research about such matters so I assumed it was a mystery. It wasn’t until years later that I came to believe that there really isn’t much of a mystery - and my theory isn’t that complicated, though putting it into words is difficult.

The fundamental difference between a closed end mutual fund and an open end mutual fund is that with an open end mutual fund the fund manager stands ready at all times to exchange shares with an investor at NAV while closed end investors have to make the exchange with each other at whatever price “the market” requires. By itself this difference wouldn’t result in a discount (or a premium) except in some special cases I’ll cover later. However, when you combine this arrangement with the fact that there are costs to managing these portfolios you get an asymmetry. In theory the value of a mutual fund should be equal to the present value of future cash flows, which derive from a combination of the investment returns minus the management expenses. In the case of a closed end fund the value should be discounted to reflect the present value of all future management expenses. In other words, at any point in time the value of the fund should be the present value of the investment returns, which is just the NAV of the portfolio, MINUS the present value of the management expenses. Let’s look at a hypothetical example where a fund distributes all of its investment returns each year, less a 1% management fee. If you discount the 1% fee at a 10% rate that would result in a 10% discount to NAV. Sound about right?

However, for an open end fund the value is just the NAV of the portfolio for two reasons. First, because of management’s guarantee that they will always pay you NAV your shares HAVE to be worth NAV. But there’s another equally valid way to think about the economics of this arrangement. Open end fund investors “pay” for management expenses on an annual basis. When they decide to sell their investment the management fees essentially go away - or at least there is no adjustment for the present value of future management expenses because the next investor who comes along agrees that they will pick up the expenses during the time period they own the shares. The fund manager essentially enforces a “transfer” of responsibility for the management expenses from one investor to the next.

If you buy my explanation then the claim by some of the charlatans out there that closed end funds allow you to buy assets at bargain prices is totally bogus. Would a gallon of milk discounted by 10% be a bargain if 10% of the milk was leaking out? Besides, what kind of bargain is it if your best bet is that you could never sell it at full price anyway?

The real mystery is why closed end funds sometimes trade at enormous discounts, don’t trade at bigger discounts than they do, and why they sometimes even trade at a premium. Usually this comes down to some kind of inefficiency in the market. A few examples:

• The Morgan Stanley China A Fund (CAF) is currently at a 29% discount. As I’ve written before, China A shares are ridiculously inflated because of restrictions placed upon this market by the Chinese government. Consequently, there is no way to arbitrage these inflated prices away and non-Chinese investors do not want to own these shares. So the fund trades at an enormous discount and most certainly does not represent a bargain.
• The First Israel Fund (ISL) is currently at almost a 7% premium but since this fund is one of the few ways to invest in this country it commands a premium.
• During 2006, when Indonesia was really hot, the Indonesia Fund (IF) briefly traded at a premium as high as 40% because there really weren’t good alternatives. Currently, as the country has fallen out of favor, it’s now trading at a 12.4% discount.

However, sometimes the discounts and premiums defy explanation and represent a temporary anomaly that you can profit from. A great example of this that I’ve written about recently is The Spain Fund (SNF), which is currently at an 18.5% premium (it’s come down from a high of 25% and, yes, I’ve racked up profits from that) despite the fact that there is a Spain ETF available that is not at a premium.

The key to earning outsized profits in closed end funds is to understand what’s driving the premiums or discounts and to carefully place bets in those cases where things don’t make sense.