The Closed-End Fund Premium Puzzle and Portfolio/Fund Risk Differences

Abstract

Seemingly at odds with market efficiency, it is well-known that closed-end funds (CEF) trade at a discount (negative premium) to the net asset values (NAVs) of the portfolios these CEFs hold. Yet, since the CEF shares and the underlying securities held by the CEF trade in completely different markets (with limited means of cross-market arbitrage), the returns on the CEF and the returns on the underlying portfolio may not move in lock-step. In this paper, we investigate whether the returns of closed-end funds (CEFs) behave differently than the returns of the underlying portfolio of securities held by the CEF. We show that, on average, the returns on CEFs have significantly (both economically and statistically) higher risk (i.e., factor loadings) and volatility than the returns on their underlying portfolios (i.e., NAV returns), but have roughly the same mean returns. We also show that the difference in risk and performance between the CEF and its NAV explain cross-sectional variation in the size of difference between the NAV and the price of the CEF (i.e., the CEF premium). Possibly adding to the puzzle though, we find that idiosyncratic risk is positively related to CEF premiums (higher relative idiosyncratic risk for the CEF results in higher relative CEF price to NAV). Our conclusion is that CEFs have a life of their own and that the difference in the return behavior rationally accounts for (at least a portion) of the CEF premium puzzle.