A Liquidity-Based Theory of Closed-End Funds

This paper develops a rational, liquidity-based model of closed-endfunds (CEFs) that provides an economic motivation for the existenceof this organizational form: They offer a means for investorsto buy illiquid securities, without facing the potential costsassociated with direct trading and without the externalitiesimposed by an open-end fund structure. Our theory predicts thepatterns observed in CEF initial public offerings (IPOs) andthe observed behavior of the CEF discount, which results froma trade-off between the liquidity benefits of investing in theCEF and the fees charged by the fund's managers. In particular,the model explains why IPOs occur in waves in certain sectorsat a time, why funds are issued at a premium to net asset value(NAV), and why they later usually trade at a discount. We alsoconduct an empirical investigation, which, overall, providesmore support for a liquidity-based model than for an alternativesentiment-based explanation.