Predictive Ability and Market Pricing of Fair Value Earnings Components for Closed-End Funds

Abstract

This study uses U.S. closed-end funds to investigate whether the realized component of fair value earnings conveys information about future fund and market performance and whether the market impounds this predictive information into fund share prices. We find that realized gains are negatively related with future fund performance. This finding is consistent with the two competing explanations for the fund managers’ trading behavior: the disposition effect behavioral bias hypothesis and the market timing hypothesis. Consistent with the market timing hypothesis, we find that realized gains together with the portion of net realizable gains that is harvested are strong predictors of future declines in the market sector used by the fund to benchmark its performance. Our market pricing tests reveal that investors in closed-end funds do not fully impound the signaling information conveyed by realized gains, and as a result, closed-end fund shares exhibit systematic mispricing of the realized component of fair value earnings. Overall, our results provide new evidence on fund managers’ ability to time the market, and we show that the realized component of fair value earnings conveys information incremental to information conveyed by aggregate earnings.