Closed-End Fund Discounts: The Market Is Very Inefficient

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

Dilip K. Patro

OCC

University at Albany, State University of New York; State University of New York at Albany

Rutgers University, Newark – School of Business – Department of Finance & Economics

Abstract:

We find significant evidence of mean reversion in closed-end fund premiums. Previous studies substantially understate the magnitudes of arbitrage profits in the closed-end fund market. Capitalizing on the property of mean reversion, we devise a parametric model to estimate expected fund returns by incorporating the information content of a fund’s premium innovation history. Our strategy of buying the quintile of funds with the highest expected returns and selling the quintile of funds with the lowest expected returns yields an annualized arbitrage return of 18.2 percent and a Sharpe ratio of 1.918, which are substantially higher than the corresponding figures produced using the extant methods. The results are robust to a wide range of tests. They greatly deepen the closed-end fund discount puzzle and pose a challenge to the market efficiency in these products.

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

Closed-end fund (CEF) are investment companies that issue a fixed number of shares and invest the proceeds based on the objective of the fund. The shares of a CEF are traded on a stock exchange similarly to common stock and unlike an open-end fund cannot be redeemed by the shareholders at its net asset value (NAV). In efficient and frictionless markets, the share price at which a fund trades must equal its NAV. In reality, however, share prices are oftentimes significantly below their respective NAVs (termed as the CEF discount puzzle). Further, the difference between share prices and NAVs, referred to as the premium1, exhibits substantial time-series and cross-sectional variation. A large body of research has tried to explain this puzzling behavior. Leading explanations include investor sentiment effects (see, e.g., De Long, et al., 1990 and Lee, et al., 1991); open-ending frictions (see, e.g., Brickley and Schallheim, 1985; Bradley, et al., 2010; and Brauer, 1985); agency costs (see, e.g., Barclay, et al., 1993; Khorana, et al., 2002 and Del Guercio, et al., 2003); managerial skills (Chay and Trzcinka, 1999; Coles, et al., 2000; Johnson, et al., 2006; and Berk and Stanton, 2007); and market segmentation (see, e.g., Bonser-Neal, et al., 1990; Bodurtha, et al., 1995; Gemmill and Thomas, 2002; Nishiotis, 2004; Cherkes, et al., 2009; Froot and Ramadorai, 2008; and Elton, et al., 2013).

This paper reports new evidence that greatly deepens the Closed-end fund discount puzzle. First, we formally test for mean reversion in CEF premium for each individual fund and find that the majority of funds exhibit significant mean reversion in the premium. Early explanations for why fund premiums should mean-revert are provided by the noise trader model of De Long, et al. (1990) and the investor sentiment hypothesis of Lee, et al. (1991). Alternatively, premiums should also display rational mean-reversion as a result of time-varying contingent liabilities as evidenced in the findings of Malkiel (1977), Chay, et al. (2006), and Day, et al. (2011). Our analysis shows that the bias-adjusted speed for mean reversion to equilibrium premium levels is 8.6 percent per month, implying an average half-life of 7.7 months for all the funds in our sample. Furthermore, there exists a large cross-sectional variation in the reversion speeds, indicating substantial heterogeneity across funds. In general, funds investing in fixed-income securities have faster speeds of reversion than funds investing in equities. International funds exhibit more significant evidence of mean reversion than funds invested domestically. Even for funds within the same fund type, there exists large cross-sectional heterogeneity in premium mean-reversion speeds.

Second, the extant literature has investigated the magnitude of inefficiency in the Closed-end fund market. Thompson (1978) finds that portfolios of Closed-end fund trading at discounts outperform the market and Pontiff (1995) shows that funds with premiums accrue negative abnormal returns and funds with discounts accrue positive abnormal returns. We propose a parametric method to optimally exploit the information contained in the history of Closed-end funds premiums and premium innovations.