A Solution to the Closed-End Fund Puzzle Without Market Frictions and Arbitrage

Abstract

We present a solution to the Closed-End Fund Puzzle in frictionless and arbitrage-free financial markets. This solution can explain both the time-series and the cross-sectional aspect of the Closed-End Fund Puzzle in a model-independent framework. The main result can be stated as follows: If the market is arbitrage free with respect to the flow of information used by the fund manager, the fund can never trade at a premium and there is no discount if and only if the fund manager applies a maximal strategy. We conjecture that most fund managers do not apply a maximal strategy. This means discounts are a natural phenomenon in an arbitrage-free financial market. Our result does not rule out the existence of premia. Nonetheless, a premium always indicates that the market is inefficient with respect to the information flow that is used by the fund manager. For example, the market could be arbitrage free with respect to the flow of public information while, at the same time, some flow of private information provides an arbitrage opportunity. In this case the fund manager has to make use of private information to realize a premium.