Heterogeneous Beliefs, Short-Sale Constraints and the Closed-End Fund Puzzle

Abstract

In this paper, we develop a theoretical model to explain the well-established empirical regularities that have been documented in the literature on closed-end funds (CEFs). In the presence of heterogeneous beliefs and short-sale constraints, both the CEF price and the price of the assets that it holds can be decomposed into two parts: fundamental value and the value of the re-sale option. Generally, the value of the re-sale option of trading a CEF is smaller than that of trading the assets that it holds, and so a CEF typically sells at a discount relative to its net asset value (NAV). We develop a number of testable hypotheses based on the theoretical model concerning CEF discounts, the volatility of belief differences, diversification, the co-movement of the discount across CEFs, the excess volatility of CEF returns, and the returns on small stocks. We test these hypotheses using data on the Chinese CEF market and find that there is considerable support for the theoretical model.