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NAV Discount Arbitrage Trading

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Written By
Dan Buckley
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Updated
Jul 3, 2024

NAV Discount Arbitrage Trading is a specialized strategy used by traders to exploit the price discrepancies between the Net Asset Value (NAV) of a fund and its market price.

This strategy is commonly applied to closed-end funds (a type of mutual fund that doesn’t continually issue new shares), where the market price of the fund can trade at a discount or premium to its NAV.

 

Key Takeaways – NAV Discount Arbitrage Trading

  • Identify Mispriced Funds
    • Look for funds trading at significant discounts to their Net Asset Value (NAV) to capitalize on price discrepancies.
    • Market value > NAV
    • Hedge by shorting an equivalent or near-equivalent asset until the desired convergence is achieved.

 

Understanding NAV and Market Price

Net Asset Value (NAV)

The NAV of a fund represents the per-share value of its assets minus liabilities.

It is calculated by dividing the total value of the fund’s assets by the number of outstanding shares.

For example, if a fund has assets worth $1 billion and 10 million shares outstanding, the NAV is $100 per share.

Market Price

The market price is the price at which the fund’s shares trade on the open market.

This price can differ from the NAV due to supply and demand dynamics, sentiment, and other market factors.

 

Concept of Discount and Premium

A NAV discount occurs when the market price of a fund’s shares is lower than its NAV.

For example, if a fund’s NAV is $100 per share but its market price is $95, then the fund is trading at a 5% discount.

A NAV premium occurs when the market price of a fund’s shares is higher than its NAV.

For instance, if the NAV is $100 per share and the market price is $105, it trades at a 5% premium.

Arbitrage Opportunity

NAV discount arbitrage involves buying shares of a fund trading at a discount and simultaneously shorting equivalent assets or derivatives to lock in a risk-free profit.

The idea is to profit when the discount narrows or the NAV and market price converge.

This convergence can take a while and can get worse before it gets better.

 

Steps in NAV Discount Arbitrage Trading

Step 1: Identify the Opportunity

Monitor closed-end funds to identify those trading at significant discounts to their NAV.

Use financial databases, market reports, or specialized software to track these discrepancies.

Step 2: Analyze the Discount

Evaluate the reasons for the discount.

Discounts can come up due to poor performance, market sentiment, or illiquid assets.

Understand whether the discount is likely to narrow based on:

  • fundamental analysis
  • market conditions, or
  • potential catalysts such as management changes or activist investor involvement

Step 3: Execute the Trade

  • Buying Fund Shares: Purchase shares of the fund trading at a discount. For instance, if a fund’s NAV is $100 and it’s trading at $95, buy 1,000 shares at $95 per share for a total investment of $95,000.
  • Shorting Equivalent Assets: Simultaneously, short sell equivalent assets or derivatives to hedge against market risk. This could involve shorting a similar index, ETF, or the underlying assets held by the fund.
  • Or Buy and Hold: This is a separate strategy, but you could also consider buy and hold and wait for convergence.

Step 4: Monitor the Trade

Keep a close watch on the NAV and market price.

Monitor news, market trends, and fund-specific developments that could impact the discount.

Adjust the hedge if necessary to maintain the risk-free nature of the arbitrage.

Step 5: Close the Trade

  • Closing Long Position: Once the discount narrows or the NAV and market price converge, sell the fund shares. For example, if the market price rises to $98 per share, sell the 1,000 shares for $98,000.
  • Closing Short Position: Simultaneously, cover the short position in the equivalent assets or derivatives.

Step 6: Calculate Profit

The profit from the arbitrage is the difference between the buying and selling prices of the fund shares, adjusted for any costs associated with the short position.

In the example:

  • Purchase cost: $95,000
  • Sale proceeds: $98,000
  • Gross profit: $3,000
  • Adjust for transaction costs, borrowing fees, and other expenses to determine the net profit.

 

Risks and Considerations

Market Risk

Arbitrage is designed to be risk-free, market risk can arise if the NAV discount widens further or if the assets used for hedging do not perfectly correlate with the fund’s portfolio.

Liquidity Risk

Closed-end funds and their underlying assets can be illiquid, making it challenging to enter or exit positions without impacting prices.

Timing Risk

The timing of the convergence between NAV and market price can be uncertain.

Holding positions for an extended period may involve additional costs and risks.

Transaction Costs

High transaction costs, including brokerage fees and borrowing costs for shorting, can erode the potential profits from arbitrage.

Let’s look at some other trade examples involving NAV discount arbitrage trading:

Example 1: Closed-End Fund Trading at a Discount

Scenario

  • Fund: ABC Closed-End Fund
  • NAV per Share: $100
  • Market Price per Share: $90 (10% discount)
  • Shares to Trade: 1,000 shares
  • Hedge Asset: XYZ Index ETF

Identify the Opportunity

  • Determine that ABC Closed-End Fund is trading at a 10% discount to its NAV.
  • Research indicates potential for the discount to narrow due to an upcoming favorable earnings report.

Analyze the Discount

  • Confirm that the 10% discount is larger than the historical average discount of 5%.
  • Identify that activist investors have recently taken positions in the fund, potentially pushing for changes to narrow the discount.

Execute the Trade

  • Buy ABC Fund Shares: Purchase 1,000 shares at $90 each.
    • Total Traded: 1,000 shares * $90 = $90,000
  • Short XYZ Index ETF: Short an equivalent value of XYZ Index ETF, which correlates closely with the assets in the ABC fund.
    • Assuming XYZ ETF trades at $100 per share, short 900 shares to hedge.
    • Short Position Value: 900 shares * $100 = $90,000

Monitor the Trade

  • Track the NAV, market price of ABC Fund, and price of XYZ Index ETF.
  • Monitor news and reports for any developments that could affect the fund or the overall market.

Close the Trade

  • Closing Long Position: The market price of ABC Fund rises to $98 per share as the discount narrows.
    • Sell 1,000 shares at $98 each.
    • Proceeds from Sale: 1,000 shares * $98 = $98,000
  • Closing Short Position: Cover the short position in XYZ Index ETF, which remains at $100 per share.
    • Cost to Cover: 900 shares * $100 = $90,000

Calculate Profit

  • Profit from Long Position: Sale Proceeds – Purchase Cost = $98,000 – $90,000 = $8,000
  • Cost of Short Position: Initial Value – Cost to Cover = $90,000 – $90,000 = $0 (assuming no change in ETF price)
  • Net Profit: $8,000 (minus transaction costs, borrowing fees, etc.)

 

Example 2: Municipal Bond Closed-End Fund Trading at a Discount

Scenario

  • Fund: DEF Municipal Bond Fund
  • NAV per Share: $15
  • Market Price per Share: $13.50 (10% discount)
  • Shares to Trade: 10,000 shares
  • Hedge Asset: Treasury Bond Futures

Identify the Opportunity

  • Determine that DEF Municipal Bond Fund is trading at a 10% discount to its NAV.
  • Upcoming interest rate cuts are expected to boost the value of municipal bonds.

Analyze the Discount

  • Historical average discount is around 5%, indicating the potential for narrowing.
  • Positive news on the interest rate cuts likely to benefit municipal bonds.

Execute the Trade

  • Buy DEF Fund Shares: Purchase 10,000 shares at $13.50 each.
    • Investment: 10,000 shares * $13.50 = $135,000
  • Short Treasury Bond Futures: Hedge using equivalent value in Treasury Bond Futures.
    • Assuming a Treasury Bond Futures contract is valued at $100,000, short 1.35 contracts (round to 1 contract for simplicity).
    • You could also do the rest of the hedge via an ETF or equivalent.

Monitor the Trade

  • Track the NAV, market price of DEF Fund, and Treasury Bond Futures.
  • Follow interest rate news and municipal bond market conditions.

Close the Trade

  • Closing Long Position: The market price of DEF Fund rises to $14.50 per share as the discount narrows.
    • Sell 10,000 shares at $14.50 each.
    • Proceeds from Sale: 10,000 shares * $14.50 = $145,000
  • Closing Short Position: Cover the short position in Treasury Bond Futures.
    • Assuming no change in Treasury Bond Futures, the cost to cover remains the same.

Calculate Profit

  • Profit from Long Position: Sale Proceeds – Purchase Cost = $145,000 – $135,000 = $10,000
  • Cost of Short Position: Initial Value – Cost to Cover = Assuming no change in Futures price, no profit or loss here.
  • Net Profit: $10,000 (minus transaction costs, borrowing fees, and so on.)

 

FAQ – NAV Discount Arbitrage Trading

What kind of trader is NAV discount arbitrage trading best for?

NAV discount arbitrage trading is best suited for traders with a strong analytical background who can effectively identify and exploit price discrepancies in closed-end funds.

These traders should have a good understanding of market dynamics, be comfortable with risk management, and have the patience to hold positions until discounts narrow.

It might take days, weeks, months, or longer for the NAV discount to close, as the strategy often requires time for the market to correct mispricings.

It’s most appealing to value-oriented traders seeking opportunities in less efficient markets.