What it means
A fund such as a closed-end fund or an investment trust holds a basket of assets, and its net asset value is the total value of those assets minus any debts, divided by the number of shares. Unlike an open-ended fund, a closed-end fund trades on a stock exchange at a price set by supply and demand.
That market price can end up above or below the NAV. When the price is higher, the fund trades at a premium.
A premium of 5% means that buyers are paying $1.05 for every $1.00 of underlying assets. When the price is lower, the fund trades at a discount.
Investors pay premiums for reasons such as strong confidence in the manager, access to an asset that is hard to buy directly, a high dividend payout, or simple popularity. Whatever the reason, you are paying more than the assets are worth today, so you are relying on the premium to persist or grow.
The premium is not stable. If sentiment cools, the premium can shrink or turn into a discount even if the assets themselves hold their value, and a buyer at a high premium can lose money without any fall in NAV.
This is one of the main risks of closed-end funds and exchange-traded products that can trade away from their NAV. Finance professionals watch the premium to judge whether a fund is expensive relative to peers and relative to its own history.
A fund that normally trades at a 2% discount but now trades at a 10% premium may be overheated. Comparing with the long-run average premium or discount is often more informative than looking at a single day.
Note that NAV is usually calculated at the end of each trading day, while the market price moves continuously. That means the premium figure shown during trading may be based on a slightly stale NAV, and it should be treated as an estimate.
In practice
Real-world examples.
Example
An investor sees that a popular emerging markets fund trades at a 12% premium to NAV. She decides to wait, noting that the fund usually trades near NAV. Two months later the premium falls to 4% and she buys at a lower price.
Example
A company treasurer reviewing a surplus cash investment finds that a bond fund's price is 3% above its NAV. He chooses a similar fund trading at a small discount. The decision saves the company about $30,000 on a $1,000,000 investment.
Example
A financial adviser explains to a client why a fund's price fell 8% even though its holdings only fell 2%. The premium to NAV had shrunk from 7% to 1%. The client understands the extra loss came from changing sentiment. The adviser suggests checking the premium before every purchase in future.
Formula
Calculation
Premium to NAV = (market price - NAV) / NAV x 100%.
A closed-end fund has net assets of $240,000,000 and 20,000,000 shares, so NAV per share = $240,000,000 / 20,000,000 = $12.00. The shares trade on the exchange at $12.60. Premium = ($12.60 - $12.00) / $12.00 = $0.60 / $12.00 = 0.05, or 5%. A buyer of 1,000 shares therefore pays $12,600 for assets worth $12,000.Case study
Seen in the real world.
Harbourview Growth Trust is a fictional listed fund used here for illustration. After a year of strong returns, its shares traded at $15.30 against a NAV of $13.00.
The premium of roughly 17.7% attracted retail investors who assumed the price reflected value. When the market cooled, the premium shrank to 2% within six months, and investors who bought at the peak lost money even though NAV fell only slightly.
In this illustrative story, a finance manager who had monitored the premium had sold early. She used the premium to NAV as a sign that expectations had run ahead of reality. The fund's discount or premium history became a standard item in her monthly investment report.
Watch out
Common mistakes.
- Assuming a premium means the fund is better. It may only mean demand is strong, and you are paying more than the assets are worth.
- Ignoring the premium when judging returns. Your return depends on the market price you paid, not just on NAV growth.
- Using a stale NAV. NAV is usually updated daily, so the premium figure can be out of date.
Questions
People also ask.
Can a fund trade at a premium forever?
It can for long periods, but there is no guarantee, and premiums often fade when sentiment changes. Funds that offer scarce exposure, such as a niche market, tend to hold premiums longer.
Do open-ended funds have premiums?
Normally not, because they issue and redeem shares at NAV, though dealing costs can apply. Exchange-traded funds can drift slightly from NAV, but traders usually keep the gap very small.
How is it different from a discount to NAV?
A discount is the opposite, where the market price is below NAV, so you pay less than the assets are worth.
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