Determinants of Cross-Sectional Difference of Closed-End Fund Discounts

ABSTRACT This study investigates empirically the determinants of cross-sectional variations in the level of closed-end fund discounts. Three types of closed-end funds, government bond funds, corporate bond funds and domestic equity funds, were investigated separately. Contrary to the past findings and popular belief, the current sample shows that bond funds were selling on average at significant discounts over the two periods. The results indicate that different types of funds have different determinants: For government bond funds and domestic equity funds, the determinants consist of both accounting (asset book value) data and market data; for corporate bond funds, the determinants consist of accounting data only. Two accounting variables, total net asset value and net asset value total year-to-date return were significant in all three models. The highly significant t-statistics for variables in the regression equations, the high explanatory power of the models as measured by R-squares and adjusted RA-squar es, and the robustness of the relationship as indicated by the inter-period results unambiguously show the rational investor behavior consistent with market efficiency. INTRODUCTION A closed-end fund (CEF) is an investment company. According to the statistics provided by the Closed-end Fund Association (http://www.CEFA.com, 2000), as of the end of 1999 the closed-end funds have grown to a $151.37 billion industry from about $56 billion in 1989. Just like an open-end mutual fund, a CEF's assets are the diversified portfolio of publicly traded stocks and other securities that it owns and manages. When a CEF is organized, a fixed number of shares are issued at initial public offering (IPO), just like any other public company. Those shares then trade on a stock exchange and new investors in the fund obtain their shares by buying them from existing investors who are looking to sell. An open-end fund, by contrast, issues new shares to each new investor within the limit on the total outstanding shares established in the company's charter. Investors who desire to sell their open-end fund shares actually have their shares redeemed by the mutual fund. While open-end fund shares are purchased and redeemed at their net asset values (NAVs, defined as the book value per share of a CEF's net assets), the market value of a share of a CEF is set by the market based on supply and demand, and may or may not correspond to the NAV of the fund's portfolio. In fact, closed-end fund shares are generally sold initially at a premium of roughly 10% of their net asset value and then fall to a discount of roughly 10% of their net asset value shortly thereafter (Sharpe, Alexander and Bailey, 1999). In the secondary market, discounts, sometimes significant, are more common than premium. This phenomenon persists in spite of the fact that the NAVs of both types of funds are readily determinable and they represent the market value of the assets held by the investment company. This is the well-known closed-end fund puzzle. Various researchers have used market study techniques to demonstrate that the discounts on closed-end funds represent market inefficiency. Weiss (1989) conducted an initial public offering (IPO) event study and found that closed-end stock funds were generally initially issued at premiums to NAVs and then selling at discounts from NAVs after 10 weeks. The discounts increased to a statistically significant average value of 10.02% after twenty-four weeks. The bond funds, on the other hand, were traded at a statistically insignificant average discount of . 012%. Thompson (1978), Anderson (1986), Brauer(1988), Byrley (1991) and Pontiff (1995) demonstrated that simple trading rules could be used to exploit the changes in discounts to earn positive abnormal returns. These researchers suggested that closed-end fund discounts provide an exception to the semi-strong form of efficient-market theory. Lee, Shleifer and Thaler (1991), in a somewhat provocative article, suggested that the one-factor capital asset pricing model is not adequate to account for the market behavior of closed-end funds. …