Closed End Fund - Explained
What is a Closed-End Fund?
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Table of ContentsWhat is a Closed-End Fund?How Does a Closed-End Investment Fund Work?Academic Research on Closed-End Investment Fund
What is a Closed-End Fund?
A closed-end fund is a type of investment fund with a predetermined unit capital and total number of shares. This type of fund has an established duration with no option for investors to redeem shares from the fund. Returns are paid based on conditions stipulated in the investment agreement.
How Does a Closed-End Investment Fund Work?
A closed-end fund is an investment fund that consists of a fixed unit capital as well as the total number of shares that cannot be altered, unless explicitly permitted by the fund management regulations. Closed-end funds have set durations and typically, do not provide investors with options to subscribe or redeem shares from their funds. This type of investment fund does not grant investors with the authority to exercise a redemption option against any asset belonging to the fund. Nevertheless, the investor is free to realize his subscribed units of the fund once they are liquidated at the end of their term. Closed-end investment funds are similar to Exchange-Traded Funds (ETFs) in that they consist of a restricted number of shares and are preliminarily launched to the public via initial public offerings (IPOs). After the fund manages to raise sufficient capital by way of the IPO, it makes its way into the open market where basic economic forces like supply and demand determine the price of the fund. However, unlike ETFs, closed-end funds are usually actively managed and can be traded at premium or discounted prices compared to the value of their holdings. Open and closed-end funds are two of the oldest types of funds, with the former being extremely popular among individual investors. Open-end funds are accessible via popular forms of pension funds such as provident funds and employer-sponsored defined benefit plans. Also, open funds practically open the doors of the stock markets to the investor and provide convenient options for him to participate in the markets at a time of his choosing. On the other hand, closed-end funds are pegged to the market price and mandate the use of the services of a broker for a buy or sell order. Another advantage of an open fund over a closed-end fund is that the former is a much safer investment since it usually offers greater liquidity. On the other hand, closed-end funds are governed by strict operational deadlines, a characteristic that often proves beneficial for investors that have tied their investments (and consequently, their profits) to fixed timeframes.
Academic Research on Closed-End Investment Fund
- Investor sentiment and the closedend fund puzzle, Lee, C. M., Shleifer, A., & Thaler, R. H. (1991). The Journal of Finance, 46(1), 75-109. Lee, Shleifer and Thaler scrutinize the hypothesis that alterations in individual investor sentiment create instabilities in discounts of closed-end funds. According to the hypothesis, there exists a coordinated movement of discounts across funds that is fueled by investor sentiment. This paper corroborates the above speculation and goes on to establish the thesis that individual investors are majorly attracted by closed-end funds and small stocks. Also, an excellent performance of small stocks at the market reduces the discounts on closed-end funds.
- The information content of discounts and premiums on closed-end fund shares, Thompson, R. (1978). Journal of Financial Economics, 6(2-3), 151-186. Thompsons paper explores the scope of calculating the expected return on closed-end investments from discounts and premiums. According to his findings for the period 1940 to 1975, discounted closed-end stock typically outperformed the market, while stocks that sold for a premium showed poor returns. The paper asserts that it is not viable to explain returns generated by closed-end funds on the basis of the two-parameter capital asset pricing model.
- An investor expectations stock price predictive model using closedend fund premiums, Zweig, M. E. (1973). The Journal of Finance, 28(1), 67-78. Zweigs paper presents a Theory of Investor Expectations that corresponds with Cootners hypothesis that stock prices display unpredictable path behaviors (or Random Walks). According to Cootner, there are two categories of market participants: A sizeable assemblage of non-professional investors that base their investments on speculations of future performance. This group typically exhibits high expenditures on market research. A much smaller group of professional investors whose research costs are much lower owing to intrinsic ideas about future stock performance.
- Open-ending'closed-end funds, Brauer, G. A. (1984). Journal of Financial Economics, 13(4), 491-507. Brauer emphasizes that a closed-end fund tends to drive its shares to assume their net asset value once it becomes open-ended. Such funds behave predictably to open-ending stimuli such as incentives as well as resistance. Also, share prices of closed-end funds begin to display impulsive surges once an open-ending is formally announced.
- Closed-end fund premia and returns implications for financial market equilibrium, Pontiff, J. (1995). Journal of Financial Economics, 37(3), 341-370. Pontiffs paper scrutinizes the relationship between the premium and return of a closed-end fund. As exemplified by Thompson in his 1978 paper, a fund premium correlates negatively with its future return. For example, a fund that carries a 20% discount is likely to offer returns that are 6% higher than that provided by non-discounted funds over a 12-month period. Pontiff attributes this correlation to premium mean-reversion.
- Managerial ability, compensation, and the closedend fund discount, Berk, J. B., & Stanton, R. (2007). The Journal of Finance, 62(2), 529-556. Berk and Stantons paper demonstrates the phenomenon that closed-end fund discounts display characteristic features subject to managerial ability as well as an established labor contract that is accepted in the industry. The duo observe that while most discount behaviors conform to quantitative data features, a few behaviors still remain inexplicable.
- Time-varying expected small firm returns and closed-end fund discounts, Swaminathan, B. (1996). The Review of Financial Studies, 9(3), 845-887. Swaminathans paper samples small firms to demonstrate the correlation between discounts offered by closed-end funds and expected excess returns that vary over time. The article concludes that such discounts can be used as variables to forecast expected excess returns. Also, closed-end fund discounts are independent of other variables, such as dividend yield. However, the results are limited to small firms.
- Are the discounts on closedend funds a sentiment index?, Chen, N. F., Kan, R., & Miller, M. H. (1993). The Journal of Finance, 48(2), 795-800. Chens article examines the paper Investor Sentiment and the Closed-End Fund Puzzle by Charles M. C. Lee, Andrei Shleifer and Richard H. Thaler. Lee and his co-authors conclude that there is a coordinated movement of discounts across funds that is fueled by investor sentiment. However, Chen rejects the above theory on the basis of systematic measurements that indicate that coordinated movement of discounts and returns of small firms are not robust enough to support the theory of common investor sentiment.
- Closedend fund shares' abnormal returns and the information content of discounts and premiums, Brauer, G. A. (1988). The Journal of Finance, 43(1), 113-127. Brauers paper asserts, with necessary evidence, that it is possible to create portfolios using discounts of closed-end funds that would deliver better returns than those prescribed by the twofactor capital asset pricing model. However, this theory does not provide details about the characteristics of the information contained in a discount.
- Costly arbitrage: Evidence from closed-end funds, Pontiff, J. (1996). The Quarterly Journal of Economics, 111(4), 1135-1151. The costs of arbitrage (or the synchronous buying and selling of securities) cause massive deviations of stock prices from their intrinsic values. Pontiff samples closed-end funds and observes that a funds market value displays the maximum deviation from fundamentals when funds have non-replicable portfolios, pay out smaller dividends, have typically lower market value, or when interest rates are high.
- The marketing of closed-end fund IPOs: Evidence from transactions data, Hanley, K. W., Lee, C. M., & Seguin, P. L. (1996). Journal of Financial Intermediation, 5(2), 127-159. Hanley, Lee and Seguin scrutinize transactions for IPOs related to closed-end funds. The authors record conditions such as flipping, large-scale price stabilization and an ensuing drop in prices and observe their correlations with each other. Their findings propose that a poorly informed public is the natural target audience of a closed-end fund IPO marketing initiative.
- The valuation of closedend investmentcompany shares, Malkiel, B. G. (1977). The Journal of Finance, 32(3), 847-859. Malkiels paper puts together a set of theoretical principles pertaining to the valuation of shares of closed-end investment firms. The author then establishes a correlation between the theoretical principles and fund discounts/premiums.