The Persistence and Predictability of Closed-End Fund Discounts

Abstract

It is well-known that the level of closed-end fund discounts appears to predict the corresponding fund's future returns. We further document that such predictability decays slowly. The popular explanations, including the tax effect, investor sentiment risk, and the funds's dividend yield, do not fully account for the observed predictability. At the same time, discounts are very persistent especially on an aggregate level. Using an AR(1) model for discounts, we demonstrate that such predictability is largely due to persistence in discounts. Our calibration exercise can produce most characteristics of an aggregate equity close-end fund index over the ten year period from 1993 to 2001. A cross-sectional study links discount persistence to rational factors such as dividend yield, unrealized capital gains, and turnover. In addition, we document a second independent source for predicting fund returns from large stock portfolio returns. This suggests that the well-known lead lag relationship between large stocks and small stocks also exists between NAV returns and fund returns. Finally, we find no evidence for "excess volatility" on the aggregate level both for conditional and unconditional volatility.

Keywords: closed-end fund, cross-correlation, discount, excess volatility, investor sentiment, large stocks, persistence, small stocks, turnover

JEL Classification: G12, G14, G19