Abstract
Theory argues that the rationale for the existence of closed-end funds (CEFs) is that they provide investors indirect exposure to their underlying illiquid assets without the high cost associated with trading them directly. Consistent with this reasoning, we show that risk-averse investors invest in CEFs to diversify their portfolios into the illiquid markets in which CEFs specialize. Moreover, investor demand for CEFs is a positive function of the CEF portfolio’s illiquidity level. A direct comparison of CEF holdings with those of CEF investors reveals that the latter underweight stocks invested by CEFs, which are typically small and illiquid. Such impacts of liquidity on investment behavior also vary across investor identities, depending on the level of fiduciary responsibility, investment horizon, and investment style. Beyond the CEF industry, our findings shed new insights on the benefits of the closed-end structure observed in other market segments.
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