Liquidity and Closed-End Funds

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 provide a means for investors to buy illiquid securities, without facing the costs associated with direct trading should they later need to liquidate their positions, and without the externalities imposed by the open-end fund structure. Our model explains both 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 predicts, as observed, that IPOs will occur in waves in certain sectors at a time, that funds will be issued at a premium to net asset value (NAV), and that they will later usually trade at a discount. Finally, calibrating the model leads to our overturning several previously accepted “stylized facts ” about the CEF discount. The model predicts that, at the time of an IPO, existing funds in the same sector should be trading at a premium, and that reversion to a discount should typically take several years. These last two predictions contradict the conclusions of prior researchers, who found that (i) CEFs come to the market at a premium at the same time as existing funds are trading at a discount, and (ii) that the reversion from a premium at IPO to a discount is of the order of months. However, their conclusions were the result of looking at the wrong, or non-representative, data. A more careful analysis shows that the model’s predictions are, indeed, correct. JEL classification: G14