A Liquidity-Based Theory of Closed-End Funds
Columbia Business School - Finance and Economics; Columbia Business School - Finance and Economics; Columbia University
University of California, Berkeley - Finance Group
Jacob S. Sagi
Kenan-Flagler Business School, UNC Chapel Hill
EFA 2006 Zurich Meetings
Sixteenth Annual Utah Winter Finance Conference
This paper develops a rational, liquidity-based model of closed-end funds (CEFs) that provides an economic motivation for the existence of this organizational form: They offer a means for investors to buy illiquid securities, without facing the potential costs associated with direct trading and without the externalities imposed by an open-end fund structure. Our theory predicts the patterns observed in CEF IPO behavior and the observed behavior of the CEF discount, which results from a tradeoff between the liquidity benefits of investing in the CEF and the fees charged by the fund's managers. In particular, the model explains why IPOs occur in waves in certain sectors at a time, why funds are issued at a premium to net asset value (NAV), and why they later usually trade at a discount. We also conduct an empirical investigation, which, overall, provides more support for a liquidity-based model than for an alternative sentiment-based explanation.
Number of Pages in PDF File: 50
Keywords: theory of closed-end funds
JEL Classification: G14Accepted Paper Series
Date posted: March 24, 2005
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