A Rational Model of the Closed-End Fund Discount

Abstract

The discount on closed-end funds is widely accepted as proof of investor irrationality. We show,however, that a parsimonious rational model can generate a discount that exhibits many of the characteristics observed in practice. The only required features of the model are that managers have (imperfectly observable) ability to generate excess returns; they sign long-term contracts guaranteeing them a fee each year equal to a fixed fraction of assets under management; and they can leave to earn more money elsewhere if they turn out to be good. With these assumptions, time-varying discounts are not an anomaly in a rational world with competitive investors -- they are required.