Discount return distributions and implications for portfolio construction

Objective: Closed End Funds (CEFs) are companies that invest in the securities of other companies for profit. They have market determined prices that differ from the net asset value (NAV) of the underlying assets and the difference is the discount. The goal of this study is to determine the distribution that best fits the empirical data of discount returns, and if that distribution has evolved over time. The distribution of discount returns is important to portfolio managers, since the discounts are in fact a major component of returns that can be earned on a portfolio of CEFs. They also add diversification benefits to portfolios consisting of other major asset classes.

Data/Methods: The sample consists of monthly discounts on all US and UK listed CEFs from August 1997 to October 31, 2014. The source of the data is from a propriety database compiled at Gramercy Asset Management. The study will search through the entire Pearson family of distributions to determine the set of parameters which best fits the empirical data. Bayesian methods similar to Markowitz and Usmen (1996) and Alparslan, Tessitore and Usmen (2013) will be used. Both the distribution of discount levels and the distribution of discount changes will be estimated with this methodology. The distributions of changes in discounts correspond to what are called “Discount Returns” (Tessitore and Usmen (2016 forthcoming)). Discount returns are a unique source of uncorrelated alpha and their probability distributions are of significant interest to global portfolios in terms of diversification.

Preliminary Results: Our sample results so far show that the distributional moments have changed in a number of ways. With respect to levels, the average discount has narrowed over the last 18 years, but its volatility has increased recently. The skewness has steadily declined and has changed from positive to negative. Kurtosis has remained approximately constant. As for discount changes, the volatility has been cut in half, but kurtosis has approximately doubled. These changes have significant implications for portfolio managers because they hint that opportunities to invest in CEFs have shifted to those funds with very deep discounts as a result of fattening tails of their distribution. The study will solidify these important observations in distributional changes by estimating the distributions at various intervals of time.