Investor sentiment and the Closed-end fund puzzle • Closed-end fund- issues a fixed number of shares that are traded on the stock market;shares are liquidated by selling the shares to other investors. • Closed-end fund puzzle- they typically sell at prices not equal to the per share market value of assets the fund holds.
Possible reasons for discount prices of closed-end fund shares • Agency costs • Tax liabilities • Illiquidity of assets • Investor sentiment theory- discounts on closed-end funds reflect expectations of individual investors
Four pieces of the puzzle • Closed-end funds start out at a premium • Although they start at a premium, the funds sell at a discount within 120 days • Discounts on closed-end funds are subject to wide fluctuations over time • On termination through a liquidation or open trading, share prices of the funds rise and discounts shrink
Investor sentiment theory • DSSW present a model of asset pricing based on the idea that the unpredictability of the opinions of not fully rational investors impounds resale price risk on the assets they trade. • Assumptions made by DSSW: • Rational investors' horizons are short • Noise traders’ sentiment is stochastic and cannot be perfectly forecasted by rational investors Other elements: -Different clienteles -Noise traders are more likely to hold closed-end funds than assets in funds’ portfolios
Investor sentiment and the 4 part puzzle • Closed-end funds sell at a discount-due to risk in holding a fund over its portfolio • Investors buy fund shares at a premium- • Discounts on closed end-funds experience wide fluctuations-due to changes in investor sentiments about future returns • On termination of fund, share prices rise due to elimination of noise trader risk
Predictions of investor sentiment model • Discounts on closed-end funds will be correlated • New funds get started when old funds sell at a premium • Discounts on closed-end funds narrow when smaller stocks do well
Conclusion • Closed-end fund discounts are a measure of the sentiment of individual investors. • This sentiment is sufficiently widespread to affect the prices of smaller stocks in the same way it affects closed-end fund prices