Investor Demand for Leverage: Evidence from Closed-End Funds

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.

In open‐end mutual funds (unit trusts), there is a strong positive cross‐sectional relationship between net inflows to individual funds and past performance, as if investors attributed performance to managerial skill. Performance shows only very weak persistence, however, so at first sight investors do not appear to gain anything by responding to past performance information. This behaviour can be explained by the fact that past performance is effectively unpriced in the unit trust market, since management fees are unresponsive to demand. If investors believe that there is a non‐zero probability that future performance will turn out to be positively correlated with past performance (i.e. that there is an element of managerial skill in performance), but a zero probability that this correlation will be negative, it is rational to prefer funds with better past performance when performance is not priced. In other words, it costs nothing to insure against the possibility of some managerial skill effect.If this explanation of the flow–performance relationship in unit trusts is correct, one would expect the relationship between investor demand and past fund performance to be much weaker if past performance were to be priced. We test this hypothesis in the market for closed‐end funds (investment trusts). Because closed‐end funds do not trade at net asset value, but at a price determined in the market, strong demand will raise the ratio of price to net asset value (known as the premium). Since it is well established that premiums are mean‐reverting, future shareholder returns on funds currently on high premiums tend to be depressed by the reversion of the premium to the mean. In the closed‐end fund market, as for open‐end funds, there is little evidence of performance persistence, and therefore, to the extent that funds with good past performance are pushed to higher premiums, the expected return on them is less than on the average fund. This implicit pricing mechanism should mean that demand is a declining function of the premium, so that, even if demand is an increasing function of past performance for a given premium, any effect on the premium itself will be muted.We test this hypothesis for closed‐end funds traded in the US and the UK. We find that there is a statistically significant effect of past performance on the premium in both countries. However, consistent with the hypothesis, it has limited economic significance, since it represents only a small component of premium variability. Copyright © 2008 John Wiley & Sons, Ltd.

This 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.

Managerial Ability, Open-End Fund Flows, and Closed-End Fund Discounts

Empirical evidence from the UK market is examined in the light of recent theories about closed-end fund discounts. Market pricing of skill, relative to the fees charged for it, accounts for a significant portion of discount variation, but cannot explain the rarity of index funds or why they trade at a discount, since fees tend to be lower than on open-end funds. Index funds have lower discount volatility, consistent with the skill hypothesis. The results imply that managerial skill, relative to the fees charged, does not wholly account for the tendency of closed-end funds to trade at a discount.

Closed-End Funds: A Survey

Possibly the earliest discussion of investor sentiment, albeit unnamed, occurred during the run-up in U.S. stocks in the spring and summer of 1929 when closed-end funds mostly sold at substantial premiums to their net asset value (see De Long and Shliefer (1991)). These early writers were involved in brokerage or portfolio management, and they were warning investors that paying premiums of 100% or more was to pay twice or more the market value for the fund’s assets. The writers were puzzled by the demand for closed-end funds and were quick to point out the superior performance that fund managers would have to achieve in order to justify the lofty premiums.

Prior Performance and Closed-End Fund Discounts

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

Structural models for valuing corporate bonds (beginning with Merton (1974)) have been criticised for giving spreads which are (a) too small and (b) have a term structure in which spreads diminish with extra time to maturity. Empirical tests of models are hampered by the complexity of real-world bonds, which have coupons, calls and sinking funds, and also by the complicated and changing capital structures adopted by companies. This paper exploits a new database of zero-coupon bonds issued by closed-end funds in the UK. These companies have very simple capital structures and transparent values for both assets and liabilities. Between 20 and 78 bonds are observable monthly over the period February 1992 to April 2001. Counter to previous research, we find that model and market spreads are on average of similar magnitude. Similar to previous research, market spreads are high (relative to model spreads) for bonds which have low risk and for bonds which are near to maturity. While the observed term-structure of credit spreads is upward-sloping, this may be explained by a predictable drift in leverage over time. On the whole, the results are surprisingly supportive of Merton’s model and suggest that it is important to allow for expected changes in leverage when computing credit spreads.

Testing Merton's Model for Credit Spreads on Zero-Coupon Bonds

Diversification of risk exposure through country mutual funds under alternative investment opportunities

RICHARD SPURGIN is an assistant professor of finance at Clark University in Worcester, Massachusetts. R ecent studies on the performance of closed-end country fund performance have concentrated on analyzing the levels and changes in fund discounts, the sources of excess volatility of closed-end funds relative to net asset value, and the pricing of closed-end country funds, as well as the implications of the introduction of closedend funds on capital market integration Ž and market efficiency Lee et al. 1991 ; Bailey and Lim 1992 ; Johnson et al. 1993 ; Diwan et al. 1993 ; Hardouvelis . et al. 1995 ; Malkiel 1995 . Most of these analyses, however, concentrate on closedend country funds traded in the United States. Few studies exist on the relative performance of comparable closed-end country funds traded in the United States and other international capital markets Ž . e.g., United Kingdom . Differences in fund clientele and market structure may explain some of the variation in the price of the fund relative to the net asset value Ž . Ammer 1992 . In this article, a paired set of comparable closed-end country funds traded in the United States and the United Kingdom are analyzed for their relative fund performance as well as their relative discount or premium to net asset value Ž . NAV . The next section reviews previous evidence on the factors that determine fund return and the discount premium of closed-end funds. The data and methodology used in the study are presented in the third section. Shares in closed-end country funds are issued in one country, referred to herein as the host country, and the fund makes investments in another country, termed the local country. If investor sentiment plays a role in the value of the fund, then there are two possible sources of changes in sentiment. Investors could be responding to changes in the local country or responding to changes in the host country. As in previous studies, we compare closed-end country fund price and discount returns with an index from the Ž host country the United States and the . United Kingdom and also the local market index. Using funds that have the same local country but different host countries allows us to gain insight into the role of the host country’s index on the discount. These results are discussed in the fourth section. Results indicate that, although the discount return may be related to investor sentiment impacts, the actual process that drives the discount is complex. Results indicate that there is a higher correlation between the discount returns and the host country index than

Mean-Reversion in Closed-End Fund Discount: Evidence from Half-Life

ABSTRACT.Romania is one of the emerging markets, where the investment funds market is less developed than in other European countries, but developing fast. The number of open-ended funds increased in the 20 years of existence of the investment market, reaching 60 in 2012. The paper looks at the open-ended funds' evolution (measured through the yearly changes in value of the fund unit), in the period 2010-2012. The main objective is to analyze the performance of the different types of mutual funds in a comparative manner and to assess them against the industry benchmark. The analysis takes place in a period of economic turmoil and based on the findings, the paper attempts to point out advices on what would be good placements for investors during economically difficult periods.JEL Classification :G23, G11, D53, E22Keywords: open ended funds, Romania, investment funds' performanceIntroductionInvestment funds represent an alternative investment opportunity to bank deposits or to direct investments on the Stock Exchange. They contribute to the development of financial markets, as new possibilities of investment for those who have available resources. Among those, open ended funds are seen as a primary instrument of investment for most individuals and households (Lenard et al., 2003). In the last decades, the role of mutual funds increased in the financial markets, as in 2007 the world mutual funds industry administered financial assets of 26 trillion USD compared to 1996 when there were administered 6 trillion USD assets (Ferreira et al., 2010).The investment funds industry in Romania is a young industry, as it has only 20 years of existence. Its youth places it as an underdeveloped market, by comparison to the U.K, Germany and France from Europe or United States from America. The industry had an initial difficult start at the beginning of 1990's, when due to the lack of regulating rules, investors lost a lot of money and registered high failures on the investment funds market. Once the market started to be better regulated, allowing for higher control and less risk of failure for investors (due to un-appropriate calculation methods), it also started to develop.The main objective of this paper is to compare the evolution of different types of open ended funds of Romania and their performances in the last years in order to identify which categories of funds performed better in the context of the present economic crisis. The evolution is measured through the funds' yearly changes in value of the fund unit.Investment funds and their performance - a literature reviewInvestment funds are organizations that gather funds from individuals and invest these funds in securities traded on the stock exchange, in money market instruments and in municipal or corporate bonds. They represent an alternative investment option to deposits in commercial banks and to direct investments on the Stock Exchange (Prisacariu et al., 2008; Bodie et al., 2009). Investment funds are classified according to different criteria: method of management, goals, the composition of the fund's portfolio, markets and investment strategy. The method of management is seen as the most important criterion to classify investment funds and according to it, there are three types of investment funds: a) unit investment trusts, b) open-ended funds and c) closed-end funds. The unit investment trusts administer a fixed portfolio that is seen as being unmanaged (Bodie et al., 2009), as compared to the other two types of investment funds (open- ended and closed-ended funds) that hold portfolios that are continuously bought and sold, therefore being managed. The open-ended funds issue permanently investment assets, allowing some investors to subscribe permanently and simultaneously allowing others to totally drop out. On the other hand, the closed-ended funds do not issue permanently and they address only to a limited number of investors, who purchase the shares when the fund is launched and redeem them when the fund closes. …