The Fundamental Theorems of Asset Pricing and the Closed-End Fund Puzzle

Abstract

We propose a solution to the Closed-End Fund Puzzle in financial markets without a free lunch with vanishing risk. Our results are consistent with both the time-series and the cross-sectional aspect of the Closed-End Fund Puzzle. It turns out that a closed-end fund cannot be created if the fund manager is supposed to receive a fee although he is not able to find overpriced assets in the market. By contrast, a premium typically occurs at the initial public offering because the fund manager has access to information that enables him to create a dominant strategy. As soon as this arbitrage opportunity evaporates, a premium can no longer occur. The reason why a premium quickly turns into a discount might be that, in a competitive financial market, a trader can earn abnormal profits only for a short period of time. Hence, when the manager is no longer able to create a dominant strategy, the fund must trade at a discount in order to compensate for management fees.

Keywords: Admissibility, Closed-End Fund Puzzle, discount, Fundamental Theorem of Asset Pricing, maximal strategy, net asset value, no arbitrage, premium.

JEL Classification: G12, G14.