Closed-end discount

An open-ended fund will always buy your units back at NAV. A close-ended fund will not, until it matures. Before then, your only exit is to find a buyer on the stock exchange.

And that buyer has the upper hand. He has cash and every other investment to choose from; you have units of one fund you want to sell. So the price he offers is usually below what the units are really worth. That shortfall is the closed-end discount.

As maturity gets closer, the discount shrinks, because the buyer knows he will soon receive the full NAV from the fund itself.

From Chapter 2:

• Investors buy close-ended units from the fund only during the NFO. After that, they trade on the stock exchange between investors; the fund is not involved and unit capital stays fixed.
• Listing is compulsory for close-ended schemes to provide liquidity; "Every close ended scheme, other than an equity linked savings scheme, shall be listed on a recognised stock exchange." Interval funds must also be listed, and so must SIF strategies launched as close-ended or interval structures.
• The exchange price depends on demand and supply and "is likely to be different from the NAV". "Experience suggests that most of the time, the units trade at a discount to the NAV." The reason: "The buyer has money, and hence many options to choose from, whereas the seller has the units… This puts the buyer in a better bargaining position."
• Liquidity in listed close-ended and interval units may be poor, and trades may be at a discount. ETFs are presented as the innovation that addresses this, with market prices tracking NAV closely.

From Chapter 12: "The price of units of a closed-end scheme in the stock exchange may be lower than the NAV. There is no limit to this discount. Typically, towards the maturity of the scheme, the market price converges towards the NAV." Investors should choose close-ended funds only if they can keep the money locked in, and match the scheme's maturity to when they need the money.

The same logic appears for segregated portfolio units, which are listed but may trade significantly lower than NAV (Chapter 10).

Discount (%) = (NAV − Market price) ÷ NAV × 100

A negative result is a premium.

NAVs and prices are illustrative.

Anand holds 8,000 units of a listed close-ended equity scheme maturing in 3 years. NAV is Rs 15.00; the best bid on the exchange is Rs 13.50.

Discount = (15.00 − 13.50) ÷ 15.00 × 100 = 10%
Value at NAV     = 8,000 × 15.00 = Rs 1,20,000
Sale proceeds    = 8,000 × 13.50 = Rs 1,08,000
Cost of exiting early            = Rs 12,000

He needs the money for a house down payment, so he sells.

His colleague holds the same scheme but can wait. Eleven months before maturity, the NAV is Rs 16.20 and the units trade at Rs 15.90:

Discount = (16.20 − 15.90) ÷ 16.20 × 100 ≈ 1.9%

The discount has narrowed, as the workbook says it typically does towards maturity. At maturity the fund pays NAV and the discount disappears.

An open-ended fund with a 1% exit load would have let Anand exit at 99% of NAV, which is why the workbook says those who value liquidity may prefer open-ended funds.

Chapter 2 (Concept and Role of a Mutual Fund) explains close-ended and interval structures, compulsory listing and why units usually trade at a discount, and introduces ETFs as the fix; Chapter 12 (Mutual Fund Scheme Selection) states that there is no limit to the discount and that prices converge to NAV towards maturity. Expect: why the discount arises, which schemes must list (all close-ended except ELSS), and convergence near maturity.

• Discount, not premium, is the usual case, because the buyer has the bargaining power.
• There is no limit to the discount.
• The price converges towards NAV near maturity.
• Close-ended ELSS is exempt from compulsory listing; other close-ended schemes must list.
• Exchange trades do not change unit capital of a close-ended scheme; the fund is not a party.
• ETFs, not close-ended funds, are designed to trade close to NAV.