A closed-end fund is much like an open-end fund, in that, it is a pool of assets managed to a specific strategy. Where is differs is in it’s structure. An open0end fund creates and redeems shares at will, changing the size of the fund daily. A closed-end fund, with a few exceptions, stays the same size. How is this possible? Closed-end funds trade on an exchange. This means that, as investor emotions and expectations rule the day, a closed-end fund can materially differ from it’s underlying portfolio value, or NAV.
Why are closed-end fund discounts an indicator? When discounts are wide, say 20% on equity funds for example, they are out of favor. When the come close to Net Asset Value, they are in demand. What can cause this swing is a reach for yield (most CEFs have an unusually high distrobution). Another reason, and perhaps more importantly, is that investors stop looking for a margin of safety. A closed-end fund at a 30% discount has a much better chance at beating it’s open-end cousin in terms of performance because of this built in margin of safety. Take care to compare a fund’s discount to it’s average, though, as a fund trading at a 15% discount vs. an average of -35% may not be a value when judged against it’s flaws.
When investors stop valuing this margin of safety appropriately, discounts narrow and they are willing to accept less benefit. When viewed in aggregate, closed-end fund discounts (and sometimes premiums) can tell you a lot about how investors as a whole view risk, because knowing how investors perceive risk can be influential in portfolio management. As Warren Buffet so famously said, “Be fearful when others are greedy, and greedy when others are fearful.”