When Is a Discount Really a Discount?

In a recent Fund Spy column, I alerted readers of the dangers of buying a closed-end emerging-markets fund selling at a steep premium (that is, when its share price is higher than its net asset value). The main risk there--besides all the usual risks of owning an emerging-markets fund--is that the premium could collapse, meaning that the fund's share price could fall or post only a meager rise even if the market was rallying and the portfolio itself was shooting upward in value.

For the most part, I wrote, only if a fund is selling at a historically deep discount is it worth considering. That raised one question from a reader worth following up on. And as I looked back at the column, it became clear there was more to say than space had allowed to help investors understand how to put premiums and discounts in context. (Note: For a basic explanation of premiums and discounts, see the first column.)

Where to Find Out?
One reader pointed out that while the first column suggested looking to see if a discount was historically deep--by which I meant in comparison with the fund's own history of discounts and premiums--it did not explain where to look for that information. The answer: The best place to look is right here on Morningstar.com. When you type in the ticker for any closed-end fund, its current share price and NAV, and the consequent discount or premium, are listed at the top right of the Snapshot page. That discount is typically drawn from the previous day's (or previous Friday's) closing share price and NAV, because funds usually don't make public their NAVs as they shift during the trading day. Although the premium or discount typically won't change by a meaningful amount during one day, make sure you still keep that in mind when evaluating these figures.

Then click on the Total Returns tab on the far left. When the Total Returns page pops up, scroll down and you'll find one bar graph illustrating the fund's month-end premiums or discounts for the past five years and, below that, another bar graph showing the weekly figures for the past three years. The month-by-month graph also includes a chart showing that fund's highest, lowest, and average monthly premiums or discounts for each year.

For example, let's look at India Fund (IFN), which I discussed in the previous column. If you look at that offering's Total Returns page, you'll see the bar graph of five-year monthly premiums and discounts. That graph makes it starkly clear why I warned against buying at a big premium: The fund has only traded at a steep markup in 2006. Prior to that the story was different. While the past doesn't provide a guarantee, the fund's history does indicate that it would not be unheard of for it to tumble to a deep discount. In fact, the graph neatly illustrates that the fund routinely sold at a discount of between 10% and 20% in 2002 and also sold at a discount for most of 2003. A glance at the weekly graph shows, even more clearly than the monthly one, that India Fund often sold at a discount even in 2005.

On the bright side, the range of premiums and discounts shown in the longer-range graph shows that if you see India Fund selling at a discount of, say, 18%, it's reasonable to think that if the Indian market rallies from that point that discount may well narrow or even turn into a premium, thus multiplying your gains. A discount just deeper than 10% might even be reasonably enticing if you've already decided you want to buy that fund.

That's not always the case, though. Take Latin America Equity . Its graphs show that the fund has traded at a discount of between 10% and 18% almost continuously for the past five years, even as Latin markets have skyrocketed and the fund has posted tremendous gains. For that fund, a 10% or 15% discount isn't all that alluring because--again, with the caveat that the past need not predict the future--there's much less evidence that the discount has a decent chance to turn to a premium or even to shrink significantly.

Buying at Premiums
The previous column warned against buying at steep premiums. But how about modest premiums? Is there a case to buy at any kind of a premium? I'd be inclined to steer clear of premiums of any size, for two reasons. One is basic: By definition, a fund selling at a premium is selling for more than its portfolio is worth in the market at that moment. Paying more than something is worth is a habit savvy investors try to avoid. Second, even funds that traditionally sell at premiums can and do fall to discounts, and you end up in the unhappy situation described in the first column, failing to pocket all, or any, of the gains the fund's portfolio is racking up.

If you choose not to follow that advice, at least allow the historical charts to provide guidance in evaluating premiums. If you have made up your mind that you want to own a fund, and the graphs show that it typically does not go to a discount, the charts can help you determine what kind of premium is typical and what would be far below average. You can try to buy at the low end of the range.

By the way, it's worth noting that all of this column's advice relates specifically to closed-end stock funds. Closed-end bond funds tend to trade in different patterns, with their premiums and discounts tied much more closely, and more logically, to the size of their dividend payout. That doesn't mean you should rush out to buy those funds at a premium, either. Rather, it means a discussion of how to evaluate closed-end bond funds--a large percentage of the closed-end fund universe--must wait for a future column.

Also, note that the discount on the Snapshot page is typically drawn from the previous day's (or previous Friday's) closing share price and NAV, because funds usually don't make public their NAVs as they shift during the trading day. Although the premium or discount typically won't change by a meaningful amount during one day, make sure you still keep that in mind when evaluating these figures.

A Final Note
Just one more reminder: Don't let the premium and discount game drive your investment decisions. First, and most important, you must decide which particular funds are worth owning and will fit your own temperament, goals, and existing portfolio. It may be that no closed-end funds meet that standard, no matter what price at which they're selling.