Closed End Funds Regress to the Mean

Back in October 2008, I wrote my first of several posts on closed-end funds:

Closed-end mutual funds, which have a fixed number of shares and are traded on stock markets, have been absolutely clobbered by the turmoil in the financial markets. Not only have their underlying net asset values gone done, but many of them are trading at historically high discounts to net asset value. There are even some municipal bond funds that normally trade at premiums that are currently trading at 25% or so discounts (in part because they are leveraged, but still, a 25% discount on a fund that will likely eventually regress to its historical mean of a small premium leaves a lot of room for error).

I’m not a fortune teller, so I don’t know whether this is a good time to invest or not. But I do know that if I owned an open-end fund, especially if I had a tax loss I could take, I’d be shopping around for a similar closed-end fund with a massive, historically unprecedented discount. For example, why own an open-end emerging markets income fund when you can own EDD at a 32% discount? (Disclosure: I don’t own this fund.) Why own an open-end corporate bond fund when a couple dozen closed-end corporate bond funds are selling at >25% discounts? And so on.

EDD is now selling at a 5% discount, and has risen over 100% since my post. In my next post, I obliquely referenced a closed-end muni bond fund, BPS, that sold for as much as a 50% discount to net asset value at the height of the panic, and now sells at a 3% discount, with the shares having risen almost 200% since Oct. 10, 2008, a rather extraordinary return for an investment in municipal bonds.

I think a great lesson of the internet bubble, the housing bubble, and the closed-end fund reverse bubble is that “regression to the mean” trumps “efficient market hypothesis” as a predictive force.

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