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Difficulty: HardInvestment Companies and Managed Funds

A registered representative is analyzing a closed-end management investment company with 120millionintotalportfolioassets,120 million in total portfolio assets, 20 million in total liabilities, and 5 million shares outstanding. The fund's shares are currently quoted on an exchange at a market price of $18.50 per share. If a retail client places a market order to buy 100 shares during normal market hours, at what price per share will the order execute, and why?

  1. A
    At $20.00 per share, because all management investment company shares are legally required to execute transactions at the net asset value (NAV) calculated at the market close.
  2. At the prevailing exchange market price of $18.50 per share, because closed-end fund shares trade in the secondary market based on supply and demand and can trade at a discount to NAV.Answer
  3. C
    At $20.00 per share plus a public offering sales load, because the order represents a primary market purchase of newly issued redeemable shares.
  4. D
    At $18.50 per share directly from the fund issuer, because investment company issuers are required to redeem and issue shares at whichever price is lower between NAV and market value.

Answer

The order will execute at the prevailing exchange market price of $18.50 per share, because closed-end fund shares trade on secondary stock exchanges based on investor supply and demand, allowing them to trade at a premium or discount relative to their underlying Net Asset Value (NAV).
Closed-end management investment companies issue a fixed number of shares through an initial public offering, after which the shares trade on secondary markets (such as stock exchanges). Because secondary market pricing is governed by investor supply and demand, closed-end fund shares frequently trade at a market price above (premium) or below (discount) their Net Asset Value (NAV). In this scenario, while the fund's NAV per share is 20.00,theclient′smarketorderexecutesattheprevailingexchangemarketpriceof20.00, the client's market order executes at the prevailing exchange market price of 18.50 per share.

Step-by-Step Solution

1
Calculate the fund's Net Asset Value (NAV) per share
NAV = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Shares Outstanding}} = \frac{\$120\text{M} - \$20\text{M}}{5\text{M}} = \frac{\$100\text{M}}{5\text{M}} = \$20.00\text{ per share}
Calculating NAV provides the baseline value per share of the fund's net portfolio holdings.
2
Identify the trading structure of closed-end management investment companies
Closed-end funds raise capital via a single initial public offering (IPO) of a fixed number of shares, after which the shares trade publicly on secondary exchanges.
Unlike open-end mutual funds, closed-end funds do not continuously issue or redeem shares directly with investors at NAV.
3
Determine the trade execution pricing mechanism
Market orders in closed-end funds execute at current secondary market prices (18.50),whichreflectmarketsupplyanddemandratherthanNAV(18.50), which reflect market supply and demand rather than NAV ( 20.00). In this scenario, the shares trade at a $1.50 per share discount to NAV.
Secondary market prices fluctuate independently of NAV based on supply, demand, yield, and general market conditions.

Key Concept

Closed-End vs. Open-End Management Company Pricing Dynamics
Estimated Time:1m 30s
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Topics

Investment Companies and Managed Funds

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