Dividend Commitment and Discount Management: The Distribution Policy of Closed-End Funds

Abstract

We show that closed-end fund managers can reduce their fund discount by adopting a target distribution policy that commits the fund to distribute at least 10% of its net assets each year. In some cases it is evident that the distribution policy is adopted in response to takeover threats and pressure from investors. We develop a simple model to show that the target distribution policy, by reducing the fund's growth rate of total net assets (TNA), lowers its anticipated exposure to non-fundamental risk (e.g., sentiment risk) - and, thereby, the fund discount. Interestingly, the discount can decrease without any change in the sensitivity of a fund to non-fundamental risk. Empirical evidence confirms that there is a positive and significant relationship between the average TNA growth rate and the level of discount, and that the commitment to a high payout ratio is essential for the target policy to be effective. Moreover, funds with the target policy tend to have higher sensitivity to non-fundamental shocks, suggesting that it is funds with larger potential discounts that have a greater incentive to adopt the target distribution policy.

Keywords: closed-end fund, payout policy, limited arbitrage, non-fundamental risk

JEL Classification: G1, G2