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Valuing a closed end feeder fund


ilike
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This is a hypothetical example but I am trying to get an idea on how to value this kind of situation.

 

We have a closed end fund trading at a discount to NAV. The company has all of its assets into a liquid open ended fund holding a major stock index like S&P500. Total fund management fees and cost of running the closed end fund is 2.5% per year.

 

The closed end fund is controlled by the management company so there is no possibility of an activist situation. However it looks kind of bad for the management company to have a big discount so they have committed to rebuying 5% of outstanding stock at NAV if the rebate is >25% at the end of every year.

 

What rebate would you require to invest in this situation?

What rebate would make it a neutral proposition?

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What the correct answer is depends on your return expectations of the underlying assets. If you would for example expect a 10% return a 25% discount would be fair since a 2.5% expense ratio would eat up 25% of the return. I think that in the current environment expecting 10%/year is kinda optimistic, so I would say that it should have a discount of at least 25%. But probably not a whole lot more, because if they buy back 5% of shares back a year with a 25% discount they will be generating 1.25% in NAV growth (effectively reducing the expense ratio by 50%). You will probably do alright if you buy a fund like this at a 30%+ discount.

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