Investments, tenth edition

  Closed-End Funds   

We noted in Chapter 4 that closed-end funds often sell for sub-

stantial discounts or premiums from net asset value. This is “nearly” a violation of the 

Law of One Price, because one would expect the value of the fund to equal the value of 

the shares it holds. We say nearly because, in practice, there are a few wedges between the 

value of the closed-end fund and its underlying assets. One is expenses. The fund incurs 

expenses that ultimately are paid for by investors, and these will reduce share price. On the 

other hand, if managers can invest fund assets to generate positive risk-adjusted returns, 

share price might exceed net asset value. 

 

Lee, Shleifer, and Thaler 

 

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 argue that the patterns of discounts and premiums on 

closed-end funds are driven by changes in investor sentiment. They note that discounts on 

various funds move together and are correlated with the return on small stocks, suggest-

ing that all are affected by common variation in sentiment. One might consider buying 

funds selling at a discount from net asset value and selling those trading at a premium, but 

discounts and premiums can widen, subjecting this strategy to fundamental risk. Pontiff  

18

   

demonstrates that deviations of price from net asset value in closed-end funds tend to be 

higher in funds that are more difficult to arbitrage, for example, those with more idiosyn-

cratic volatility.  

 Closed-end fund discounts are a good example of apparent anomalies that also may 

have rational explanations. Ross demonstrates that they can be reconciled with rational 

investors even if expenses or fund abnormal returns are modest.  

19

   He shows that if a fund 

has a dividend yield of  d , an alpha (risk-adjusted abnormal return) of  a , and expense ratio 

of á, then using the constant-growth dividend discount model (see Chapter 18), the pre-

mium of the fund over its net asset value will be

  

Price

2 NAV

NAV

5

a

2 á

d

1 á 2 a

   

 If the fund manager’s performance more than compensates for expenses (i.e., if  a  > á), 

the fund will sell at a premium to NAV; otherwise it will sell at a discount. For example, 

suppose  a   5  .015, the expense ratio is á  5  .0125, and the dividend yield is  a   5  .02.  Then 

the premium will be .14, or 14%. But if the market turns sour on the manager and revises 

its estimate of  a  downward to .005, that premium quickly turns into a discount of 27%. 

  

17

 C. M. Lee, A. Shleifer, and R. H. Thaler, “Investor Sentiment and the Closed-End Fund Puzzle,”  Journal of 

Finance  46 (March 1991), pp. 75–109. 

  

18

 Jeffrey Pontiff, “Costly Arbitrage: Evidence from Closed-End Funds,”  Quarterly Journal of Economics   111 

(November 1996), pp. 1135–51. 

  

19

 S. A. Ross, “Neoclassical Finance, Alternative Finance and the Closed End Fund Puzzle,”  European Financial 

Management  8 (2002), pp. 129–37,   http://ssrn.com/abstract  5  313444  . 

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Final PDF to printer

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P A R T   I I I

  Equilibrium in Capital Markets

 This analysis might explain why the public is willing to purchase closed-end funds at a 

premium; if investors do not expect  a  to exceed á, they won’t purchase shares in the fund. 

But the fact that most premiums eventually turn into discounts indicates how difficult it is 

for management to fulfill these expectations.  

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 Fundamental risk may be limited by a “deadline” that forces a convergence between price and intrinsic 

value. What do you think would happen to a closed-end fund’s discount if the fund announced that it 

plans to liquidate in 6 months, at which time it will distribute NAV to its shareholders? 

 CONCEPT CHECK