Empirical Test of the Liquidity-Based Theory of Closed-End Funds

Theory argues that the rationale for the existence of closed-end funds (CEFs) is that they provide investors indirect exposure to their underlying illiquid assets without the high cost associated with trading them directly. Consistent with this reasoning, we show investor demand for CEFs is a positive function of the CEF portfolio’s illiquid-ity level and a negative function of the CEF stock illiquidity. Using choice-modelling framework, a direct comparison of CEF holdings with those of CEF investors reveals that the latter underweight stocks invested by CEFs, which are typically illiquid in nature. Although the observed investment patterns vary across investor identities depending on their fiduciary duties, portfolio turnover, and investment styles, the re-sults are largely consistent with the liquidity-based explanation of the CEFs. Further, our results survive a series of robustness tests and alternative empirical methodolo-gies. Beyond the CEF industry, our findings shed new insights on the benefits of the closed-end structure observed in other market segments such as real estate investment trust, listed private equities, and secondary market traded hedge funds