Excess volatility and closed‐end fund discounts

The purpose of this paper is to examine the conditions under which discount risk leads to closed‐end funds trading at a discount.

A model of investor portfolio choice is developed in which investors face proportional fees for holding managed funds but fixed transaction fees for purchasing other risky assets. The conditions under which investors will hold shares in closed‐end funds are derived.

It is shown that, with fixed transaction costs in the market for risky assets, investors with wealth below a certain threshold will hold pooled index funds that charge a proportional fee, rather than the market portfolio chosen by wealthier investors. If a portfolio of closed‐end index funds yields greater volatility of returns to investors than open‐end index funds (i.e. displays “excess volatility”), and charges the same fees, the closed‐end funds need to trade at a discount in equilibrium to attract buyers. The same applies to actively managed funds if higher fees fully reflect extra expected returns from the managers' skill.

A primary determinant of closed‐end fund discounts is discount volatility and co‐movement across funds.

Until now it has been argued that discount risk needs to be systematic (correlated with market returns) to be priced. The evidence that discount risk is systematic is weak. There is strong empirical evidence of excess volatility and co‐movement of discounts across closed‐end funds, which in our model are a sufficient condition for funds to trade at a discount, under plausible assumptions. This model thus provides a stronger argument that discount risk explains why discounts exist.