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A Rational Model of the Closed-End Fund Discount

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  • Jonathan Berk
  • Richard Stanton
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    Abstract

    The discount on closed-end funds is widely accepted as proof of investor irrationality. We show,however, that a parsimonious rational model can generate a discount that exhibits many of the characteristics observed in practice. The only required features of the model are that managers have (imperfectly observable) ability to generate excess returns; they sign long-term contracts guaranteeing them a fee each year equal to a fixed fraction of assets under management; and they can leave to earn more money elsewhere if they turn out to be good. With these assumptions, time-varying discounts are not an anomaly in a rational world with competitive investors -- they are required.

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    File URL: http://www.nber.org/papers/w10412.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10412.

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    Date of creation: Apr 2004
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    Handle: RePEc:nbr:nberwo:10412

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    1. Kim, Chang-Soo, 1994. "Investor Tax-Trading Opportunities and Discounts on Closed-End Mutual Funds," Journal of Financial Research, Southern Finance Association & Southwestern Finance Association, vol. 17(1), pages 65-75, Spring.
    2. Kathleen Weiss Hanley & Charles Lee & Paul Seguin, 1995. "The Marketing of Closed-End Fund IPOs," Center for Financial Institutions Working Papers 94-21, Wharton School Center for Financial Institutions, University of Pennsylvania.
    3. Chay, J. B. & Trzcinka, Charles A., 1999. "Managerial performance and the cross-sectional pricing of closed-end funds," Journal of Financial Economics, Elsevier, vol. 52(3), pages 379-408, June.
    4. Pontiff, Jeffrey, 1997. "Excess Volatility and Closed-End Funds," American Economic Review, American Economic Association, vol. 87(1), pages 155-69, March.
    5. Zweig, Martin E, 1973. "An Investor Expectations Stock Price Predictive Model Using Closed-End Fund Premiums," Journal of Finance, American Finance Association, vol. 28(1), pages 67-78, March.
    6. Pontiff, Jeffrey, 1996. "Costly Arbitrage: Evidence from Closed-End Funds," The Quarterly Journal of Economics, MIT Press, vol. 111(4), pages 1135-51, November.
    7. Constantinides, George M, 1983. "Capital Market Equilibrium with Personal Tax," Econometrica, Econometric Society, vol. 51(3), pages 611-36, May.
    8. Lee, Charles M C & Shleifer, Andrei & Thaler, Richard H, 1991. " Investor Sentiment and the Closed-End Fund Puzzle," Journal of Finance, American Finance Association, vol. 46(1), pages 75-109, March.
    9. Jonathan B. Berk & Richard C. Green, 2002. "Mutual Fund Flows and Performance in Rational Markets," FAME Research Paper Series rp100, International Center for Financial Asset Management and Engineering.
    10. Brauer, Greggory A, 1988. " Closed-End Fund Shares' Abnormal Returns and the Information Content of Discounts and Premiums," Journal of Finance, American Finance Association, vol. 43(1), pages 113-127, March.
    11. Roenfeldt, Rodney L. & Tuttle, Donald L., 1973. "An examination of the discounts and premiums of closed-end investment companies," Journal of Business Research, Elsevier, vol. 1(2), pages 129-140.
    12. Brickley, James A & Manaster, Steven & Schallheim, James, 1991. "The Tax-Timing Option and the Discounts on Closed-End Investment Companies," The Journal of Business, University of Chicago Press, vol. 64(3), pages 287-312, July.
    13. Lee, Charles M C & Shleifer, Andrei & Thaler, Richard H, 1990. "Closed-End Mutual Funds," Journal of Economic Perspectives, American Economic Association, vol. 4(4), pages 153-64, Fall.
    14. Thompson, Rex, 1978. "The information content of discounts and premiums on closed-end fund shares," Journal of Financial Economics, Elsevier, vol. 6(2-3), pages 151-186.
    15. Peavy, John W, III, 1990. "Returns on Initial Public Offerings of Closed-End Funds," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 695-708.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Exotic Investing: Closed End Funds
      by PKamp3 in DQYDJ.net on 2009-07-21 14:52:25
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    Cited by:
    1. Lily Qiu & Ivo Welch, 2004. "Investor Sentiment Measures," NBER Working Papers 10794, National Bureau of Economic Research, Inc.

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