Fear and Closed-End Fund Discounts: Investor Sentiment Revisited

The disparity between closed-end funds¡¯ net asset values and prices has been the focus of numerous research papers over the past half century. Various explanations for this discrepancy have been investigated, with mixed findings. A relatively recent topic is that of the role of small investor sentiment in the pricing of these funds¡¯ shares. Lee, Schleifer, and Thaler (1990, 1991) propose a theory that explains the divergence in fund share prices and underlying values through the behavior of noise traders whose activities create an additional source of risk for which rational traders need to be compensated. Other researchers have questioned this view. In this article, we provide a new analysis of the potential role of investor sentiment by utilizing a latent factor structure to estimate the dynamic conditional correlations between fund discounts and VIX, which is a measure of the implied volatility of S&P 500 index options, often referred to as the fear index. Using a sample of funds over the 2004-2011 period (thus incorporating the market meltdown of 2007-2009), we find results strongly consistent with the sentiment theory.