Sentiment, Expenses and Arbitrage in Explaining the Discount on Closed-End Funds

51 Pages Posted: 20 Apr 2000

See all articles by Gordon Gemmill

Gordon Gemmill

Warwick Business School

Dylan C. Thomas

Queen Mary Unversity of London

Abstract

Theory suggests that the persistent discount on closed-end funds is caused by management expenses, while investor sentiment contributes to its volatility. However, empirical studies have tended to support neither of these theories. In this paper we begin by showing how expenses and arbitrage may generate a plausible discount in the UK of about 13%. Cross-sectional tests on 158 equity funds over seven years find that the direct causes of smaller discounts are youth, ease of replication, large size and high dividend yield. Once age of fund is taken into account, the results support the hypothesis that larger expenses are associated with larger discounts. To test for the short-term impact of sentiment on the discount, we use monthly flows from retail investors into open-end funds as a proxy for retail-investor sentiment. Based on cointegration analysis of data by sector, we find a very strong short-term relationship between the closed-end fund discount and retail-investor sentiment. Finally, using data over the last 30 years, we find that discounts widen when the stockmarket is low, at which time small investors hold a much smaller proportion of the funds' shares than normal. Our study supports a rational basis for the existence of a long-run discount, while confirming that both short and medium-term fluctuations are related to investor sentiment.

Keywords: Sentiment, discount, closed-end fund, agency cost, arbitrage, cointegration

JEL Classification: G12, G23

Suggested Citation

Gemmill, Gordon and Thomas, Dylan C., Sentiment, Expenses and Arbitrage in Explaining the Discount on Closed-End Funds. Cass Business School Research Paper, Available at SSRN: https://ssrn.com/abstract=222448 or http://dx.doi.org/10.2139/ssrn.222448

Gordon Gemmill (Contact Author)

Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Dylan C. Thomas

Queen Mary Unversity of London ( email )

United Kingdom

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