The tax-timing option and the discounts on closed-end investment companies

Abstract

In two important papers, Constantinides (1983, 1984) investigates the influence of taxes on security returns. He observes that the purchase of any taxable security confers on its owner a taxtiming option to recognize capital gains and losses in an optimal fashion. Each investor will use the options to maximize his wealth by minimizing his expected liability.1 The ability to tax in this fashion will be reflected in the market price of each asset. Constantinides' model and empirical evidence suggest that the value of an asset's tax-timing option is a positive function of the variance of an asset's before-tax rate of return. For all options, including tax-timing options, a portfolio of options is more valuable than an option on the corresponding portfolio. This observation is consistent with the puzzling empirical regularity that closed-end funds sell at discounts from their net asset value. Consistent with this theory, our results show that, crosssectionally, the discounts are positively correlated with the average variance of the constituent assets in the fund and that in time series the value of the discount varies countercyclically. Estimation of a specific model was not sufficiently precise to provide additional insights into the pricing of taxtiming options. *We are grateful to Sanjai Bhagat for comments and for helping to provide access to SEC data. The paper also has benefited from comments from Sudipto Bhattacharya, Jeff Coles, Ron Masulis, Chester Spatt, and workshop presentations at the universities of Arizona, Arizona State, Georgia Tech, Oklahoma, Southern Methodist, Washington State, Utah, Vanderbilt, and the Japan Security Research Institute in Tokyo, Japan. We also acknowledge especially helpful comments by an anonymous referee. We appreciate research assistance by Rick Carter, Robert Hanson, Kiyoshi Kato, and especially Denise Woodbury. 1. Constantinides' analysis is limited to the study of the implications for portfolios of only one stock, although some plausible speculation is provided regarding the influence of timing on portfolios of many assets. A problem exists in that the functional form for the value of the taxtiming option is not available for portfolios of more than one asset. In addition, the optimal tax-timing strategy for portfolios of many assets has not yet been derived.