Limited participation and the closed-end fund discount

In this paper, we present economic forces that affect the closed-end fund share price using a simple two-period model with limited participation. We characterize three economic forces: management fee, principal-agent problem effect and diversification benefit effect. The role of the management fee is consistent with recent studies by Ross [Ross S., 2002. Neoclassical finance, alternative finance and the closed end fund puzzle. European Financial Management 8, 129–137, Ross, S., 2002. A neoclassical look at behavioral finance: closed end funds. The Princeton lectures in finance III] and findings of various empirical studies [e.g., Kumar, R., Noronha, G.M., 1992. A re-examination of the relationship between closed-end fund discounts and expenses. Journal of Financial Research 15(2) Summer, 139–147; Russel, P.S., 2005. Closed-end fund pricing: The puzzle, the explanations, and some new evidence, Journal of Business and Economic Studies 11(1), 34–49; Gemmill, G., Thomas, D.C., 2002. Noise trading, costly arbitrage, and asset prices: Evidence from closed end funds. Journal of Finance 57(6), 2571–2594]. The model’s principal-agent problem effect is consistent with empirical findings by Brickley et al. [Brickley, James, Steven Manaster, Schallheim, James, 1991. The tax-timing option and the discounts on closed-end investment companies. Journal of Business 64, 287–312] of positive relation between the fund discount and the average variance of the constituent assets in the fund portfolio. In addition, it provides a theoretical framework for empirical studies, which examine the role of agency costs [Barclay, Michael J., Clifford G. Holderness, Jeffrey Pontiff, 1993. Private benefits from block ownership and discounts on closed-end funds. Journal of Financial Economics 33, 263–291] and compensation contracts [Coles, J., Suay, J., Woodbury, D., 2000. Fund advisor compensation in closed-end funds. Journal of Finance 55 (3), 1385–1414; Deli, Daniel N., 2002. Mutual fund advisory contracts: An empirical Investigation. Journal of Finance 57(1), 109–133] on the behavior of fund managers and fund discounts. The model’s diversification benefit effect supports the result in [Bonser-Neal C., Brauer,G., Neal, R.., Wheatley, S., 1990. International investment restrictions and closed-end country fund prices. Journal of Finance 45, 523–547] that announcement of financial market liberalization is associated with a decrease in the fund premium. It also supports the findings of [Kumar, R., Noronha, G.M., 1992. A re-examination of the relationship between closed-end fund discounts and expenses. Journal of Financial Research 15(2) Summer, 139–147; Chay, J.B., Trzcinka, Charles A., 1999. Managerial performance and the cross-sectional pricing of closed-end funds. Journal of Financial Economics 52, 379–408] of a positive relation between current premium and the risk-adjusted return over the following year.