Asymmetric Information and the Closed-End Fund Puzzle

Although investors attain better diversification by investing in mutual funds, this benefit along cannot explain why the market price for a closed-end fund is usually different from the current value of the portfolio held by the fund, or its net asset value (NAV). The authors provide a rational explanation by showing how the organization feature of the closed-end fund can lead to discounts or premia in equilibrium. They highlight tow roles the fund can play - providing information and creating new securities. The authors explain the closed-end fund puzzle as an equilibrium phenomenon which arises due to the organization feature of the fund when the fund manger has private information. In their model, the fund manger performs tow important economic roles. Although the fund is not a redundant asset, its price is determined contingent on the price of the underlying risky asset. Consequently, discount or premium naturally occurs in equilibrium. The authors suggest two future research topics. The first is to determine the optimal closed-end fund contract at a set-up state. Since this optimal contract will determine the investment rule of the fund, figuring out an optimal contract is essential for complete resolution of the puzzle. The second is the analysis of open-end funds where the investor will change the number of shares of the open-end fund as he learns from the price of the risky asset.