Close End Fund Puzzle

Published Date: 02 Nov 2017

Behavioral Finance

ASB –

Close-end Fund Puzzle

Reem Jehad Bukamal

500322164

26th April 2013

Word count: 1,485

Mutual funds, which are formed for the purpose of investments, are made up of a pool of funds gathered from many investors, which are then reinvested, on their behalf in different securities. Such funds give small investors the ability to participate in professionally managed and diversified portfolios of securities which would otherwise be difficult to achieve with a small amount of capital. Mutual funds are classified into close-end funds and open-end funds. What differentiates the two types is that in a close-end fund the number of issued securities and shares that are traded on the stock market are fixed. Therefore, the shares which are bought by the investors are non-redeemable thus when an investor wishes to liquidate their shares they can only do so by selling it to other investors in the fund. The price of the shares traded in the find are determined by the supple and demand of the market. In a close-end fund, the Net Asset Value per share is used to determine the market value of assets the fund holds.

The close-fund puzzle arises due to the shares of the fund being traded at a discount relative to their NAV, which therefore presents a puzzle for market efficiency. In general they sell at a discount of 10%-20% to the NAV per share. This differentiates close-end fund from open-end funds since the later trades at a price of the determined NAV of shares.

In their discussion of the close-end fund puzzle, Charles Lee, Andrei Shleifer, and Richard Thaler (1991) suggest four parts to describe the puzzle. They start by implying that the initial price of shares traded in the fund when first set up is charged with a 10% premium that represents underwriting fees and start up costs. This point suggest that investors with less knowledge about the financial markets tend to rely on advisors and would therefore trade securities through a full-fee broker. Hence, the premium charged in the initial stage of trading represent the underwriting fees and start up costs.

Secondly, they suggested that within the first 120 days of trading the prices of the shares move to a discount of 10%. According to Hanley, Lee, and Seguin (1996) the fund manager who’s responsible for the trading/investment will provide support for the fund prices only for a short period of time after the initial trading (approximately 120 days). Later they would reduce the support thus the premium is represented in the discount within the 120 days.

Furthermore, the third part suggested indicates that the percentage of the discount deviates regularly, hence its fluctuating. In the case of close-end funds, it’s suggested that fluctuations/inconsistency in investors sentiment is one of the reasons behind the fluctuation in discount since the demand is affected. Fluctuations in demand for close-end funds are reflected in changes in discount.

The last and fourth part indicates that when in liquidation or when converting into open-end fund, close-end funds share price tends to increase while the discount decreases. This is because of the nature of open-end funs, since they normally trade at the share’s NAV. Hence, when converted into an open-end fund the prices increase.

Economic Explanations for the discount:

According to Andrei Shleifer, there are three possible explanations to the close-end fund puzzle discount, which also address the four parts of the puzzle discussed earlier. These include agency costs, illiquidity of assets, and tax liabilities, however they don’t account for market efficiency.

It is likely for agency costs to create discount for close-end funds if management fees are too high – Boudreaux (1973) or if future management performance is expected to be low. Nevertheless, agency costs fail to fully explain the theory of close-end fund puzzle, this is because it’s not possible for agency costs to account for the wide fluctuations in discounts as part three of the puzzle suggests. In addition, management fees represent a fixed percentage of NAV, thus they don’t fluctuate rapidly as discounts. Hence, even when management fees are high, they don’t create wide fluctuations in discounts, thus in this case; agency costs cannot be a valid explanation for the close-end fund puzzle.

The second explanation, which is illiquidity of assets, implies that the NAV determined by the fund overstates the true value of the assets. The theory suggests that the funds hold a significant amount of restricted stocks which are usually overvalued when calculating for the NAV. According to Malkiel (1977), there’s a relationship between the amount of restricted stocks held by the fund and the level of discount. Therefore, restricted stocks can offer an explanation for the discount present in small less diversified funds, but not for large diversified funds that hold a variety of different stocks. The theory of illiquidity of assets also fails to explain the puzzle because funds have a restricted exposure to illiquid assets, such as the restricted stock.

Finally, the theory of tax liabilities suggest that capital gains tax, which are realized when the assets are sold in the fund, are not being reflected in the NAV of close-end funds. Considering US close funds, it’s possible to distribute the net realized capital gains to shareholders, if this was the case, shareholders are then obliged to pay tax based on the distributions. This therefore could offer an explanation for the discount. Yet, Malkeil (1977) explains that capital gain tax liabilities could only account for approximately 6% discount. On the other hand, UK close funds do not allow for capital gains distribution, therefor implying that capital gain tax liabilities fail to explain discount since both US and UK funds perform similarly.

To sum up the above, the explanations suggested were able to clarify the second part of the puzzle, but haven’t been successful in explaining the other remaining three parts. The above economical explanations have been successful in explaining how the discount is created, but failed to fully explain the reason behind starting the fund, the fluctuations in discount and the realization of abnormal returns when the close-end fund is liquidated or open-ended.

Behavioral Explanations for the discount:

Another potential explanation to the close-end fund puzzle is investor sentiment. Zweig (1973) was the first to believe that discounts reflect individual investors expectations. At times when investors are optimistic about the return of assets in the fund, the prices tend to increase, and when pessimistic the price of the asset decrease. Therefore, the inconsistent sentiment of investors results in fluctuations in the value of the assets in the fund. Hence, in the case of close-end funds, the optimism of investors leads to the assets being sold at a premium or at a higher price, and investor’s pessimism leads to the assets being sold at discount. Thereby, the inconsistency of investors is able to cause unpredictable fluctuations to the close-end fund discount.

Lee, Shleifer, and Thaler (1991) further agreed with this suggestion showing that the closed-end fund discount reflects investor sentiment. They imply that there are two types of investors in the close-end fund market, rational and irrational, also know as "noise" traders. It is believed that noise traders have unpredictable expectations of movements in the fund, which therefore creates a risk for the rational investors who are more likely to be risk averse. They argue that discounts appear due to the noise trader compensation which rational investors demand. Evidence shows that rational investors will only invest in the fund if it trades at a discount, in order to compensate for the noise trader risk.

Another explanation for the close-end fund puzzle is regarding returns on small firms. Under this theory, it is suggested that individual/irrational investors also hold and trade in small firm stocks, therefore any changes in individual investors sentiment that effects close-end funds should also affect small firms stock. Lee, Shleifer, and Thaler (1991) support this theory as they explain how discounts tend to narrow as small firm stocks perform well. Therefore, they prove that as discount on close-end fund narrow, small stocks perform well.

In conclusion, many theorists have addressed this topic from different perspectives and presented a number of suggestions to explain the puzzle. Some of these theories fail to consider market efficiency including agency costs, illiquidity of assets, and tax liabilities.

Literature suggested that the over-valuation of NAV could be a reason behind the discounts, however this doesn’t support the existence of premiums in close-end funds. Agency costs were also used to explain the puzzle, due to high management fees or management underperformance. Nevertheless, agency costs fail to provide full explanation for the puzzle, because of the wide fluctuations in discounts which it does not support. Tax liability theory attempts to explain the puzzle as well, but this theory is inconsistence due to the difference between US and UK funds.

Nonetheless, there is no definite theory, yet, that gives a significant evidence for the puzzle, as some of the theories were successful in explaining parts of the puzzle and failed to explain the remaining parts.

Lee, C. M., Shleifer, A., and Thaler, R (1991). ‘Investor Sentiment and the close-end fund puzzle’. Journal of Finance, 46:75-110.

Boudreaux, K. J. (1973). ‘Discounts and premium on close-end mutual funds: A study in valuation’. Journal of Finance, 28:515-22.

Malkiel, B. (1977). ‘The valuation of close-end investment company shares’. Journal of Finance, 32:847-59.

Zweig, M. (1973). ‘An investor expectations stock price predictive model using close-end fund premiums’. Journal of Finance, 28:67-87.

Hanley, Kathleen Weiss, Charles M. C. Lee, and Paul Seguin. 1996. "The marketing of close-end fund IPOs: Evidence from transaction data." Journal of Financial Intermediation 5:127-159.

A. Shleifer (2000), Inefficient Markets: an Introduction to Behavioural Finance. Oxford University Press Inc., New York.

H. Shefrin (2002), Beyond Greed and Fear: Understanding Behavioural Finance and the Psychology of Investing.

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