Deviations from fundamental value and future closed-end country fund returns.
| Autor | Berggrun, Luis |
-
Introduction
Closed-end funds (CEFs) are investment companies that issue a fixed number of shares and invest the resources pursuing the objective of the fund. Unlike more popular open-end funds, CEF shares (traded on a stock exchange) cannot be redeemed by investors at their net asset value (NAV). It is now widely acknowledged that CEF share prices trade at levels that are significantly different from the market value of the assets that the CEF invests in. This phenomenon is known as the closed-end fund puzzle. According to Roenfeldt and Tuttle (1973), even though some funds trade at a premium (i.e. share prices are higher than NAV per share), discounts of 10 and 20% are the norm for CEFs. In addition, premiums and discounts appear to have a life cycle. Based on Lee et al. (1991) this cycle has four parts: (1) CEFs start trading at a premium of almost 10%. By and large, the premium is related to setup costs that reduce NAV (but not share prices) (2) 120 days after the inception of the fund, discounts are close to 10%. From this moment on, discounts are more likely to occur than premiums (3) discounts are subject to great variability in time and (4) in a merger, liquidation or conversion of the CEF to an open-end fund, discounts narrow and converge to zero.
Market inefficiency implies that market participants can obtain abnormal returns by exploiting return predictability based on past returns or other variables. The extant literature has shown the inefficiency of the CEF market because of the assets that the CEF invests in, and the CEF itself should trade at equivalent prices (following the law of one price). Furthermore, given that the CEF is nothing more than a portfolio of assets, discounts are a clear violation of the additivity concept that implies that in a perfect market, the value of a group of assets must equal the sum of the individual assets that belong to the group. In this document, we explore another type of market inefficiency, whether deviations from fundamental value (i.e. whether funds trade at a discount or premium) can forecast future CEF returns. This would be a clear violation of market efficiency in its weak form (Fama, 1970).
This study focuses on a specific type of closed-end fund. We concentrate on closed-end country funds that invest in a single country. Among the different types of CEFs in the USA (municipal bond, taxable US bond, diversified US equity, sector and speciality, global and international, and single-country funds), single country funds are possibly more subject to systematic or non-systematic risk, noise trading and considerable information asymmetries. These three features make our study more interesting and justify our sample choice.
-
Literature review
Several papers have analysed the closed-end fund puzzle and put forward alternative explanations for the presence of discounts or premiums. The most common explanations are related to rational and behavioural factors.
Some studies support the rational explanation of market segmentationas adeterminant of CEF premiums or discounts. Kim and Song (2010) find that the higher the investment barriers [both direct and indirect (e.g. political risk)] that foreign investors face, the higher the premium of closed-end country funds that trade in the USA. This positive relationship supports the idea that investors derive diversification gains when trading in CEFs (and thus are willing to pay share prices that exceed NAVs), and that CEFs are a way to bypass investment restrictions in the funds' local or target markets [1]. Davies et al. (2017) find a different effect of market segmentation on CEF prices and NAVs. They use a time-varying measure of market segmentation for the UK-traded closed-end country funds (that invest in emerging markets) and report that direct barriers to foreign investors are negatively related to both closed-end fund price and NAV returns. Overall, both NAV and prices tend to decline after the enforcement of barriers possibly due to the expectation of lower capital flows directed towards the segmented (country) market.
Davies et al. (2013) examine another rational explanation related to illiquidity. They study the impact of both fund and country illiquidity on the premium of UK closed-end country funds. Using a sample of funds that invest in either developed or developing markets, they find that fund illiquidity is not significant in explaining the premium (after considering several control variables). Interestingly, they also document that the premium and country illiquidity are positively related indicating that increasing (country) illiquidity augments the premium. This positive relationship implies that investors are willing to pay more for foreign markets that are deemed more illiquid but offer more upside potential.
An additional rational explanation to CEF discounts or premiums is related to the extent of arbitrage activity. Lee et al. (1990) analyse the two strategies an arbitrageur can implement when the CEF trades at a premium or discount. If the CEF trades at a premium, the arbitrageur can sell the fund short and go long on the underlying portfolio. In countries with restricted or segmented markets, this strategy is difficult and costly, and thus deviations from intrinsic value may be justifiable from a rational point of view. If the CEF trades at a discount, the strategy is straightforward: liquidate the fund or open-end it (so the discount vanishes). Nevertheless, taking over a fund is difficult given (among other reasons) the fierce resistance of fund managers. Yet, discounts may be justifiable from a rational perspective.
In more recent literature examining arbitrage and deviations from fundamental value, Alexander and Peterson (2017) find evidence that is consistent with an efficient market in which short-selling activity occurs often in the CEF market. Interestingly, short-selling occurs for funds that trade at a premium and even at a discount. Furthermore, premia and discounts tend to revert to fundamental values consistent with the idea that investors push prices towards equilibrium levels (e.g. premiums decline over the next five days after short-selling activities increase).
On the other hand, a behavioural explanation for the premiums or discounts in the CEF market is related to the presence of non-informed (or "noise") investors that create an additional risk for rational (or fundamental) investors. The idea is that this risk (or noise trader risk) commands a price and could be a plausible explanation for the difference between NAV and share prices.
Lee et al (1991) argue that irrational investors are more prevalent in the ownership of CEFs than in the ownership of the underlying assets of the funds. When irrational investors become pessimistic about the future, the market value of the CEF dwindles (below NAV), and...
Para continuar leyendo
Solicita tu pruebaCOPYRIGHT GALE, Cengage Learning. All rights reserved.
