Closed-end Fund Discounts Research Articles

What drives closed‐end fund discounts? Evidence from COVID‐19

AbstractThis paper investigates the impact of the onset of the COVID‐19 pandemic in the United States on closed‐end fund (CEF) discounts. I show that CEF discounts increased after the onset of the COVID‐19 pandemic in the United States, while individual investor sentiment declined. Furthermore, CEFs with higher retail ownership had a larger discount increase, which suggests that individual investor sentiment is a potential contributor to CEF discounts. This finding seems less likely to be driven by rational channels or income‐driven fire sales, as shown by further analysis. Overall, the results shed light on the CEF discount puzzle using a new setting.

Closed-End Fund Discounts and Economic Policy Uncertainty

This paper empirically tests the determinants of closed-end fund (CEF) prices by employing cointegration and error-correction modeling with an advanced ARDL framework. Since CEF shares generally trade at discounts to their net asset value (NAV), we modeled CEF prices, including volatility and economic policy indices along with their NAVs. The present study consists of 31 monthly frequency CEF discount data from January 1999 to April 2018 and economic policy uncertainty (EPU) with ten subindices. This paper finds evidence for cointegration in many of the series and statistically significant coefficients in the short- and long-run estimates of the included subindices.

What Drives Closed-End Fund Discounts? Evidence from COVID-19

By exploiting the exogenous COVID-19 shock, this paper attempts to shed light on the closed-end fund (CEF) discount puzzle. CEF discounts increased after COVID-19, and I identify a causal role of sentiment in this effect. I show that COVID-19 reduced individual investor sentiment. Using the difference-in-differences (DiD) approach, I find that CEFs with higher sentiment beta or higher retail ownership experienced a larger increase in discounts after the COVID-19 shock. The DiD results are unlikely to be driven by alternative channels such as the liquidity, expense, payout, and leverage channels. Overall, the results support the sentiment-based explanation of CEF discounts.

The Impact of Investor Sentiment on Stock Market Liquidity: The Mediating Role of Investor Herding Behavior “An Empirical Study on the Egyptian Stock Exchange”

Behavioral finance is a recent approach in financial markets that have appeared because of the complexities long faced by the traditional or neoclassical finance theory. This paper investigates the influence of investor sentiment and herding behaviour on stock market liquidity using an empirical study on the Egyptian Stock Market. We examine the direct impact of Egyptian investor sentiment on the Egyptian Stock Market liquidity. As well as the indirect impact of the Egyptian investor sentiment on the Egyptian Stock Market liquidity through the Egyptian investor herding behaviour. Therefore, the major contribution is filling the gap of indirect sentiment-liquidity impact conflict. We use the monthly data of the EGX30 index from January 2004 up to December 2018 for building up investor sentiment index, investor herding behaviour, and stock market liquidity measures. Moreover, we are using two additional types of data (closed-end mutual fund discounts and the equity open-end mutual fund flows) that represent major measures which are used to build up investor sentiment index ranging through the same time-series of the previously mentioned period of this paper. Additionally, we use four control variables for stock market liquidity, namely market volatility, excess market return, term spread, and lag of the dependent variable, considering that the fourth variable is also used for investor herding behaviour. Our result shows that the investor sentiment index has both a direct and indirect impact on stock market liquidity. In addition, regarding event study analysis’ results, there are different signs of the direct and indirect impacts and different correlations between the research variables throughout the four different events that differ completely from the usual signs and correlations of the theoretical background.

Investor Demand for Leverage: Evidence from Closed-End Funds

We provide evidence that investors with leverage constraints demand leverage, for the sake of leverage. We study the equity closed-end fund (CEF) market and document a strong negative relation between fund leverage and CEF discounts, indicating that investors pay a relative premium for leverage. We show that leverage changes do not signal improved fund performance. Instead, the only benefit to investors of increased leverage is amplified exposure via greater volatility and risk exposure. We utilize a quasi-natural experiment to identify leverage as a causal driver of demand and provide external validity by relating our results to the betting-against-beta factor.

Retail Trader’s Noise risk and closed-end fund pricing puzzle Investor Sentiment Model for Closed-end Equity Funds Pricing Puzzle an Empirical Study

This empirical study investigates the rationale for the United States (US) closed-end equity fund discounts using investor sentiment approach of C. Lee, Shleifer, and Thaler (1991) for the period from 2004 to 2013. The result of this study suggests that discounts on closed-end equity funds decrease when small stocks return increase. The closed-end fund discounts have the significant stronger correlation with small capitalization as compared to large company’s stock returns. The results indicate that similar noise trading risk generated by retail traders explains the fluctuations in closed-end fund discounts and small capitalization equity returns even after controlling for fundamental factors. The results validated the existence of noise traders in market producing stochastic demand and supply based on their belief, subsequently affecting closed-end equity fund price in the market.

A Rational Asset Pricing Model for Premiums and Discounts on Closed-End Funds: The Bubble Theory

This paper provides a new explanation for closed-end fund (CEF) discounts and premiums using the local martingale theory of asset price bubbles. This is a rational asset pricing model that is shown to be consistent with the existing empirical evidence on CEF discounts/premiums. Additional testable implications of the model are derived which await subsequent research for their resolution. This bubble theory also applies equally well to understanding discounts and premiums on exchange traded funds (ETFs).

The Limits of Arbitrage and Stock Mispricing: Evidence from Decomposing the Market to Book Ratio

The purpose of this paper is to investigate the effect of the of on securities mispricing. Specifically, I investigate the effect of the availability of substitutes and financial constraints on stock mispricing. In addition, this study investigates the difference in the limits of arbitrage, in the sense that it will lead to lower mispricing for these stocks, relative to non-S&P 500 stocks. I also examine if the lower mispricing can be attributed to their lower limits of arbitrage. Modern finance theory and efficient market hypothesis suggest that security prices, at equilibrium, should reflect their fundamental value. If the market price deviates from the intrinsic value, then a risk-free profit opportunity has emerged and arbitrageurs will eliminate mispricing and equilibrium is restored. This arbitrage process is characterized by large number of arbitrageurs which have infinite access to capital. However, a better description of reality is that there are few numbers of arbitrageurs to the extent that they are highly specialized; and they have limited access to capital. Under these condition arbitrage is no more a risk-free activity and can be limited by several factors such as arbitrage risk and transaction costs. Other factors that are discussed in the literature are availability of substitutes and financial constraints. The former arises as a result of the specialization of arbitrageurs in the market in which they operate, while the latter arises as a result of the separation between arbitrageurs and capital. In this dissertation, I develop a measure of the availability of substitutes that is based on the propensity scores obtained from propensity score matching technique. In addition, I use the absolute value of skewness of returns as a proxy of financial constraints. Previous studies used the limits of arbitrage framework to explain pricing puzzles such as the closed-end fund discounts. However, closed-end fund discounts are highly affected by uncertainty of managerial ability and agency problems. This study overcomes this problem by studying the effect of limits of arbitrage on publicly traded securities. The results show that there is a significant relationship between proxies of limits of arbitrage and firm specific mispricing. More importantly, empirical results indicate that stocks that have no close substitutes have higher mispricing. In addition, stocks that have high skewness show higher mispricing. Subsequent studies show that the S&P 500 stocks have different levels of liquidity, analysts’ coverage and volatility. These characteristics affect the ability of arbitrageurs to eliminate mispricing. Preliminary univariate tests show that S&P 500 stocks have, on average, lower mispricing and limits of arbitrage relative to non-S&P 500 stocks. In addition, the multivariate test shows that S&P 500 members have, on average, lower mispricing relative to non-S&P 500 stocks.

Valuing Investment Management Fees, Active Portfolio Management, and Closed-End Fund Discounts

Risk-neutral valuation is used to value a portfolio and decompose it into the components accruing to its stakeholders. The analysis incorporates managers’ expected performance and contract renewal issues. A managed portfolio’s economic value is shown to differ from its net asset value. A better foundation for computing fair closed-end fund discounts and a partial explanation of equilibrium in the markets for open and closed-end mutual funds are provided. Tests on the behavior of net redemptions following closed-end fund open-endings and the relation between premiums and investment performance around IPOs strongly support the paper’s theory.

Costly Arbitrage and the Closed-End Fund Puzzle: Evidence from a Natural Experiment

We examine how short sale constraints on portfolio holdings affect closed-end fund (CEF) discounts and thereby distinguish behavioral-based explanations from fundamental-based explanations of the discounts. Using Regulation SHO as a natural experiment that relaxes short-sale constraints on pilot stocks, we find that discounts of CEFs holding more pilot stocks decrease relative to CEFs holding fewer pilot stocks. We also find that the effect comes only from CEFs that trade at discounts. The results suggest that a substantial part of CEF discounts is driven by mispricing.

Turnover And Closed-End Fund Discounts

This paper seeks to further investigate the quandary of closed-end fund discounts known as the four-piece puzzle. While other researchers have taken a behavior approach (investor sentiment, etc.), this study will explore empirical data on several variables, including some Fama-French factors. Using a fixed effects model, the effects of turnover, three-year-beta, price/book, median market capitalization, expenses and income were measured in this study.

Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient than You Thought

We systematically study the value of the information contained in closed-end fund (CEF) premiums. We parametrically estimate CEF expected returns as a function of the history of CEF premiums, in addition to the current premium, and buy the quintile of funds with the highest expected returns and sell the quintile of funds with the lowest expected returns. The return on this portfolio suggests that previous studies, which examine the information in current premiums only, have understated the value of the information in premiums. Our strategy values the information in the history of CEF premiums at an annualized return of 18.2%.

Closed-End Fund Discounts and Irrational Investors

It is widely believed that Closed-End Fund (CEF) discounts are due to the relatively disproportionate large numbers of small investors compared to institutional investors trading in them. An asset that is mainly traded by small investors has additional risk due to the fear factor that is usually associated with incomplete information about the market conditions. According to the present sentiment theory, noisy traders, which are usually small investors, are the reason behind CEF discounts. To test this discount theory, a closer study of the CEF funds and their correlations to various market indicators is presented. A special attention is paid to the behavior of CEFs during the financial crisis. It is shown that CEFs, contrary to popular belief, are relatively safe with small β and high α in many cases. This partially explains why CEFs are still a good investment even if they are traded at a premium and our results show that the sentiment theory cannot explain the origin of the discount.

Does investor sentiment predict stock returns? The evidence from Chinese stock market

This paper examines the proxy variables of investor sentiment in Chinese stock market carefully, and tries to construct an investor sentiment index indirectly. We use cross correlation analysis to examine lead-lag relationship between the proxy variables and HS300 index. The results show that net added accounts (NAA), SSE share turnover (TURN), and closed-end fund discount (CEFD) are leading variables to stock market. The average first day return of IPOs (RIPO) and relative degree of active trading in equity market (RDAT) are contemporary variables, while number of IPOs (NIPO) is a lagging variable of stock market. Using the sentiment proxy variables with most possible leading order, and forward selection stepwise regression method, the empirical results on monthly stock returns reveal that three leading proxy variables can be used to form a sentiment index. And the out of sample tests prove that this sentiment index has good predictive power of Chinese stock market, and it is robust.

The market pricing of the lifeboat provision in a closed-end fund

It is well known that a closed-end fund (CEF) tends to trade at a discount from its net-asset value (NAV) after a certain time of operations (e.g. Lee et al. 1990). CEF discounts are often regarded...

Closed-End Fund Abnormal Returns and Discount Mean-Reversion

Swedish investment companies structured as closed-end funds (CEFs) are large relative to CEFs in the U.S. and elsewhere. Their costs are low and they trade at high and mean-revering discounts. I show that CEF returns are usually in excess of what can be explained by conventional risk factors. I decompose returns into return on CEF assets, return due to leverage, return due to changes in discount and other (abnormal) return. The latter is significantly positive for a portfolio of CEFs. This is exploited in a trading strategy which delivers abnormal returns of more than 10% annually. The CEFs are in essence conglomerates with listed holdings. This makes it possible to disentangle different reasons for the conglomerate discount. Discounts cannot be (fully) explained by inefficiencies, costs and potential agent problems. This suggests that investors do demand a discount for investing in a portfolio they cannot chose themselves.

Fear and Closed-End Fund discounts

Closed-End Fund (CEF) discounts have intrigued researchers for decades. Of the many explanations offered, the behavioural framework of Lee et al. (1991), which posits noise traders subject to sentiment, is the most discussed. In this article, we contribute some novel evidence to the evaluation of this theory by examining the role of implied market volatility (VIX, i.e., the ‘fear index’) in fund discounts using a Dynamic Conditional Correlation (DCC) approach. We find that VIX has almost no role in determining discounts except during periods of extreme market turbulence, providing strong but indirect evidence for the sentiment story.

Probability Weighting and Asset Prices

In the present paper, we estimate a monthly index of aggregate skewness preference. This index is derived from the representative agent's nonparametric probability weighting function. Consistent with findings from lab experiments, probability weighting functions depend on sentiment and their average is inverse-S shaped. Induced skewness preference varies over time and explains the size (value) premium over and above three (two) Fama and French factors and a momentum factor. Closed-end fund discounts signal a desire to underdiversify during times of high skewness preference. Higher skewness preference leads to more low quality IPOs with higher delisting probability.

Activist Arbitrage, Lifeboats, and Closed-End Funds*

We present a dynamic rational expectations model of closed-end fund discounts that incorporates feedback effects from activist arbitrage and lifeboats. Both activist arbitrage and lifeboats distort closed-end fund prices and lead to narrower discounts. Furthermore, both activist arbitrage and lifeboats effectuate an ex post wealth transfer from managers to investors but an ex ante wealth transfer from low-ability managers to high-ability managers. On average, investor wealth is unaffected by either activist arbitrage or lifeboats because their potential benefits are factored into higher fund prices. Although lifeboats can reduce takeover attempts, they do not increase expected managerial wealth.

Directors’ Ownership and Closed-End Fund Discounts

This paper investigates whether ownership by independent directors could provide them with effective monitoring incentives and thus help reduce discounts in the closed-end fund industry. We find that after controlling for fund observed and unobserved characteristics with the latter proxied by fund fixed effects, independent directors’ ownership is negatively related to fund discounts. We further find that funds whose independent directors have larger ownership are more likely to employ appropriate measures to reduce fund discounts, such as buying back outstanding shares, adopting managed distribution plans (MDPs) if they do not have such plans in place, or increasing the minimum payout targets under their existing MDPs. These findings may imply that independent directors become better monitors when they have larger ownership in the funds they oversee and are thus more diligent in taking actions to diminish discounts.