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Closed-End Funds: A Survey

Article in Annual Review of Financial Economics · October 2012

DOI: 10.1146/annurev-financial-110311-101714

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First published online as a Review in Advance on closed-end, discount, investor sentiment, liquidity transformation
September 5, 2012

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New theories have emerged over the past 10 years that reveal CEFs
to be an important and efficient organizational device. This review
surveys the old and current literature on closed-end funds (CEFs) in
general and theories of discounts in particular. Among the topics
reviewed are liquidity transformation, the effects of tax overhang,
the importance of managerial fees, the provision of leverage services,
the impact of the potential irrationality of small investors on dis-
counts, and rationality of CEFs’ initial public offering (IPO) process.

431
 1. INTRODUCTION
This review deals with a tiny fraction of the mutual fund universe—closed-end funds
(CEFs). I concentrate on the subset of the recent articles about CEFs and to save space, I do
not define terms that were defined by Musto (2011). A CEF1 is organized as an exchange-
listed corporation; it holds annual shareholder meetings, elects a board of directors, pays
dividends, and hires outside portfolio-management advisors, i.e., a closed-end fund is the
simplest corporation where the assets are a portfolio of traded securities and the capital
structure could have a leverage component. Shareholders can exit a CEF by selling shares
in a secondary market; the CEF has no obligation to redeem investors’ shares (i.e., to
provide liquidity), hence the term “closed.” Open-end funds [OEFs; introduced in 1924
(see Musto 2011)], the most common type of mutual funds, have a legal obligation to
redeem investors’ shares at the per-share net asset value (NAV). The provision of liquidity
(or the redemption mechanism) is the institutional difference that gives rise to very dif-
Annu. Rev. Fin. Econ. 2012.4:431-445. Downloaded from www.annualreviews.org

ferent fund-management organizations. CEFs and OEFs differ with regard to their portfolio
holdings, fee structures, turnover ratios, and investment strategies (see Cherkes 2003, who
compares OEFs and CEFs specializing in the same assets). They also differ in importance:
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OEFs collectively manage 50 times more assets than CEFs do [Investment Company
Institute (ICI) 2011]. Nevertheless, over the past 30 years, more than 100 articles dedi-
cated exclusively to CEFs have been published in peer-reviewed journals, and over the
past 10 years, more than 80 new articles have been posted on the SSRN. CEFs are a
cause célèbre because they have generated a long list of perceived deviations from the
efficient markets paradigm (known as puzzles). All such puzzles stem from the fact that
the market value of all the shares of a CEF (its capitalization) often differs from the net
value of its portfolio. A positive difference between the NAV and the capitalization,
which is known as the discount2 and reported as the percentage difference between the
NAV and the exchange-traded price, is an apparent arbitrage opportunity.3 Its presence raises
issues of market efficiency and investors’ rationality: Are CEFs an example of investors’
irrationality and of security prices that do not reflect the fundamental value of the under-
lying assets (see for example Summers 1986 who is one of many that make this claim)?
The answer to this question has repercussions far beyond the limited field of CEF research.
For example, Ross (2002b, p. 133) points out in his magisterial Keynote Address at the
2001 European Financial Management Association Meetings that the behavioral challenge
to neoclassical finance consists of only one empirical fact that is considered “. . .to be an
irrefutable challenge to neoclassical theory: [t]his mysterious case of the closed-end funds.”
This review concentrates on four topics. First, I summarize the evolution of ideas in
this field, including the main contributions. Second, I discuss different theories about
discounts. Third, I discuss services that a CEF offers to its shareholders and analyze the
decision to offer a new CEF versus a new OEF. Finally, I address the so-called CEF initial
public offering (IPO) puzzle. I also review the use of CEFs as a laboratory in which to
study questions in corporate finance.
I survey approximately 70 articles, a fraction of the total available. Some topics and
contributions are by necessity left out; thus, readers should also consult an earlier survey
(Dimson & Minio-Kozerski 1999).

1
The first CEF in the United States was launched in 1889; see Dimson & Minio-Kozerski (1999).
2
A negative difference is known as a premium.
3
One buys all the shares and sells the assets to pocket the difference.

432 Cherkes
 2. THEORIES ABOUT DISCOUNTS
In the academic literature, Pratt (1966, p. 79) was the first to document the presence of
discounts and to explain them as arising from “lack of sales effort and [lack of] public
understanding.” Malkiel (1977, p. 847) provides the first careful analysis of the possible
causes of discounts, finds all of them lacking in explanatory power, and concludes that
“[t]he pricing of closed-end fund shares. . .provide[s] an illustration of a market imper-
fection in capital-asset pricing.”
Malkiel’s list of possible reasons for discounts [which includes bookkeeping procedures,
managerial fees, managerial skills, and unrealized capital appreciation (Malkiel 1977,
p. 847)], along with factors such as investors’ irrationality and market segmentation, is
still being discussed 35 years later, and no consensus has been reached regarding the
source of discounts.4 New developments worth mentioning are the renewed interest in
management fees as a source of discounts, the realization that CEFs invest mainly in
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illiquid assets while their shares are more liquid than their holdings, and the emergence of
models that juxtapose managerial fees versus managerial skill or versus liquidity transfor-
mation as a basis for a rational explanation for the discount puzzles. Two broad approaches
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that aim to explain the discount puzzles appear in the literature: (a) the investor sentiment
theory, which invokes the irrational behavior of small investors, and (b) several new models
that utilize the trade-off between CEF managerial costs and CEF investment services to
offer a rational explanation for the puzzles. We begin with the investor sentiment approach.

2.1. Investors’ Irrationality

Lee, Shleifer & Thaler (LST) (1991) report several surprising regularities in discount time-
series data: Discounts of different funds exhibit a strong correlation, discounts converge
to a mean, and discounts are correlated with returns on small-cap stocks—even if the
funds do not invest in small-cap stocks. LST also observe that new CEFs are offered in
waves when the seasoned CEFs trade at premiums or small discounts, and that new CEFs
are IPOed at a premium, whereas within 100 days they trade at a discount.
Following Zweig’s (1973) insight, LST (1991) offer an explanation for these observa-
tions with their investor sentiment theory (built on De Long et al. 1990). The theory is
based on two assumptions and one empirical fact: Small investors (sometimes referred to
as noise traders) are the predominant traders of CEF shares (an empirical fact); they are
driven by irrational bouts of optimism and pessimism (an assumption about small inves-
tors’ irrationality); this irrationality causes greater share-price volatility and the latter
cannot be diversified (another assumption). In other words, the investor sentiment risk
has to be compensated for by an additional risk premium, known as the noise traders’
risk premium.
As for LST’s explanation, CEF shares have to trade at a discount to compensate for the
additional risk factor (the compensation for noise traders’ risk premium). The comovement

4
As for the size of the discount, various studies published since Pratt (1966) quote different numbers. Here is a
random sample: Chay & Trzcinka (1999) arrive at an average discount of approximately 12% among equity CEFs
and an average discount of approximately 4% among bond CEFs in their 1965–1993 sample. Malkiel & Xu (2005)
arrive at an average discount of 8.42% in their 1993–2002 sample of 60 equity CEFs. Cherkes, Sagi & Stanton (CSS)
(2009) estimate an average discount of approximately 6.2% among domestic-equity CEFs and an average discount
of approximately 3.4% among municipal bond CEFs in a sample of all existing CEFs between 1984 and 2005.

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Closed-End Funds: A Survey 433

 and conversion to mean are explained by fluctuations in investor sentiment. Investor opti-
mism raises the prices of existing CEFs and creates demand for new CEFs.
LST (1991) has had a tremendous impact on the profession, igniting the academic
interest in CEFs and being by far the most-cited article in this area. Empirical research
guided by the investor sentiment theory’s insights followed. For example, this theory
would predict a CEF price to be more volatile than the CEF holdings, if the CEF holdings
are less exposed to investor sentiment than the CEF shares are. Indeed, Pontiff (1997,
p. 155) finds that the average CEF’s monthly return “. . .[is] 64 percent more volatile than
its assets” and that the excess volatility is largely idiosyncratic—as investor sentiment
would suggest.
In another example, the theory would predict that the noise traders’ premium is mean-
reverting; Thompson (1978, p. 152) finds a negative correlation “between closed-end fund
discounts and the future expected abnormal return performance of their stock.” Pontiff
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(1995, p. 341) finds that funds “with 20% discounts have expected twelve-month returns
that are 6% greater than non-discounted funds” (but see Chay & Trzcinka 1999).
LST’s (1991) empirical findings have been replicated and supported by many other
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studies; the most-cited articles are mentioned below. Pontiff (1995, p. 343) provided
broad empirical support for investor sentiment theory by finding that the “cross-sectional
pattern of [CEF] premia is related to exposure to investor sentiment risk.” Bodurtha,
Kim & Lee (1995); Klibanoff, Lamont & Wizman (1998); and most recently Hwang (2011)
validate LST’s theory by using the closed-end country funds’ data. Kumar & Lee (2006)
validate LST’s theory by using the buy–sell imbalance data among retail investors.
The investor sentiment theory is disputed by Chen, Kan & Miller (1993, p. 798) on
econometric grounds. They observe that “. . .the return on [CEF’s] net asset value explains
only 72.8 percent of the return on closed-end fund share prices. That, in an important
sense, after all, is the closed-end fund puzzle.” They also observe that LST’s (1991) model
adds in explanatory power “nowhere more than 4 percent (above the 72.8%) of the
variance in closed-end fund returns” (Chen, Kan & Miller 1993, p. 798).
The investor sentiment theory is also disputed by Elton, Gruber & Busse (1998, p. 478),
who use 25 years’ worth of NYSE data to show that “. . . small investor sentiment, as
measured by the change in the discount on closed-end funds, is (not) an important factor
in the return generating process for common stocks,” and by Gemmill & Thomas (2002,
p. 2572), who use UK data to find that “the level of the discount is driven primarily by
arbitrage costs and managerial expenses” and not by noise traders (but see Flynn 2012,
who uses US data to replicate the Gemmill & Thomas study and finds support for the
investor sentiment hypothesis). The investor sentiment theory would predict that a CEF’s
shares earn higher returns than its holdings, but Sias, Starks & Tinic (2001, p.312) do not
find that a CEF’s investors earn an excess return (when compared with investors in the
CEF’s portfolio) and conclude that “there is no evidence [of] noise trader risk [being]
priced.” The costly arbitrage findings of Pontiff (1996) and of Gemmill & Thomas (2002)
may indicate that investor sentiment risk could be arbitraged away. For a more nuanced
critique of LST’s (1991) conclusions see Neal & Wheatley (1998) and Swaminathan (1996).
Direct verification of the investor sentiment theory requires an independent (not a CEF
data–based) measure of the sentiment. Several proxies for sentiment (based on con-
sumer confidence surveys) are utilized by Qiu & Welch (2006), Lemmon & Portniaguina
(2006), and most recently by Ramadorai (2012) (also see Schmitz, Glaser & Weber 2009).
The results are surprising: The proxies for sentiment do correlate with small stocks’

434 Cherkes
 returns but not with a CEF discount index. Sentiment appears to “[play] a role in financial
markets. . .but the [CEF discount index]. . .may be the wrong measure of sentiment” (Qiu &
Welch 2006, p. 6)
Another weakness of this theory is its inability to explain why, at any given moment,
approximately one-third of seasoned CEFs, on average, trade at a premium. For example,
as of February 2, 2012, there are approximately 630 funds, with 60% trading at a dis-
count and 40% at a premium (see http://www.cefconnect.com). The investor sentiment
theory is unable to explain the simultaneous presence of premiums and discounts among
otherwise similar funds.

2.2. Managerial Fees versus Liquidity Services

Boudreaux (1973) conjectures that a CEF should trade at a discount if managers add
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no value, and Ingersoll (1976) derives this result in a valuation model. However, Malkiel
(1977) finds weak empirical support for fees as a possible source of discounts, and LST
(1990, p. 156) reject fees as a source of discounts on general grounds: CEFs charge “fees
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that are comparable to those of large no-load mutual funds. Since both are providing
similar services, it would seem that both should sell at the same price.”
Attempts to measure the direct impact of the managerial fee on discount are hampered
by a severe endogeneity problem: Fees are endogenous and are influenced by the size of the
discount (the practitioners’ literature is replete with news about CEFs cutting their man-
agerial fees in response to high discounts). Still, Kumar & Noronha (1992), Gemmill &
Thomas (2002, 2006), Cherkes (2001), and CSS (2009) provide evidence for the impor-
tance of fees as a source of discounts.
A promising way to avoid endogeneity is through event studies. Between 1990 and
2006, some 40% of equity CEFs adopted so-called managed distribution plans (MDPs),
which are de facto commitments for a gradual decrease in the dollar value of annual
managerial fees. If managerial fees are the source of discount, this commitment should
impact discounts at the policy inception date. Indeed, Johnson, Lin & Song (2006) find
that the discount of MDP-adopting funds decreases by one-third during the first post-
announcement week. Cherkes, Sagi & Wang (2011) calculate the difference-in-difference
changes before MDP and after MDP versus a control group without MDPs. They calculate
the difference-in-difference for discounts, for managerial fees as a percentage of the NAV,
and for the dollar value of annual managerial fees. The difference-in-difference for dis-
counts was 5.3% (the difference went from 1.9% before MDP to þ3.2% after MDP),
the difference-in-difference for managerial fees as a percentage of the NAV statistically
did not change, and the difference-in-difference for annual managerial fees in dollars
was $0.46 MM (see their table 3a).These authors interpreted their findings to mean
that the change in discounts reflects the capitalized value of $0.46 MM savings on
managerial fees.
The modeling of fees as a source of discount (as has been done by Ross 2002b,
Gemmill & Thomas 2002, Berk & Stanton 2007, Cherkes 2001, and CSS 2009) calcu-
lates the capitalized value of fees as a managerial claim on the fund’s NAV. When the
value of managerial contribution is zero, a discount must ensue as managerial fees are
paid out of the fund’s assets earnings. To get a CEF that trades at a premium, we need a
source of value. Ross (2002b), Berk & Stanton (2007), and Cherkes (2001) suggest
managerial ability as a source of value added, whereas CSS (2009) build on value added

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Closed-End Funds: A Survey 435

 by liquidity transformation. I discuss the Berk & Stanton model later and deal with
liquidity transformation below.
Mutual funds provide portfolio services by specializing in different asset classes (e.g.,
stocks versus bonds), different horizons of assets (e.g., money market funds versus long-
term bond funds), and different liquidities of assets. Chordia (1996) shows that funds
choose a fee structure and the terms of liquidity provision (or the lack thereof, as in the
case of CEFs) to position their holdings along a liquidity spectrum: Funds that provide
liquidity on demand hold more liquid assets, and funds that do not provide liquidity at all
hold mainly illiquid assets. Chordia shows that the CEFs in his sample hold predominantly
illiquid assets. Nanda, Narayanan & Warther (2000) explain that CEFs are able to con-
centrate their investments in illiquid assets because CEFs are protected from liquidity
withdrawal shocks, whereas OEFs are not. Datar (2001, p. 120) suggests that “discounts
are observed when a fund is less liquid than the assets in its portfolio.” Both Datar and
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Deli & Varma (2002) utilize several liquidity measures and verify that discounts are
sensitive to the liquidity of CEF shares.
CSS (2009) make the next step: They claim that the higher liquidity of CEF shares
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(when compared with their holdings) is a design feature, in particular, that CEFs transform
the liquidity of their holdings as the value-adding service. CSS support this conjecture by
showing that the bid-ask spread for shares of municipal bond CEFs is 0.5%, whereas
the bid-ask spread for small trades in the illiquid holdings of these CEFs can be as high
as 10% (when trades are small—$10,000 or less). This difference provides the economic
rationale for the existence of CEFs: They transform illiquid assets into liquid securities to
facilitate small investors.
Benveniste, Capozza & Seguin (2001)5 supply an empirical estimate of the value
added by this transformation: An exchange-traded real estate investment trust (REIT)
increases the valuation of its illiquid assets by packaging them into an exchange-traded
security. The authors determine that a REIT (by creating liquid shares from illiquid real
estate) “increases value [for that real estate] by 12–22%” (Benveniste, Capozza & Seguin
2001, p. 633).
As for CSS’s (2009) explanation of discounts/premiums, they contrast the benefit
of liquidity transformation with the capitalized managerial costs; the result is positive
(premium) or negative (discount) on a case-by-case basis. They also build on works of
Chordia (1996) and Nanda, Narayanan & Warther (2000) to explain why funds that
choose to specialize in highly illiquid assets have to be closed. This observation yields to
a positive theory of CEFs—as suggested by Cherkes (2003) and CSS (2009).

2.3. Managerial Fees and Asymmetric Information About Fund

Managers’ Abilities
Berk & Stanton (2007) extend Ross’s (2002a) work to develop a rational model that links
fund discounts to both management fees and investors’ perception of managerial ability.
Because both factors can be time varying, the fluctuation in the discount or premium
depends on whether the perceived managerial ability outweighs the management fees.
In this model, the abilities of a new manager are not known to either the investors or the
manager; as the manager accumulates on-the-job time, both she and the investors learn

5
I thank Dr. Capozza for bringing this article to my attention.

436 Cherkes
 about her abilities. If her abilities are mediocre, she will earn her guaranteed compensation,
which is above her contribution. However if her abilities are good, the fund will trade at
a premium before she requires and gets a raise—and then the fund will slip into discount.
The interplay between abilities, managerial compensation, and managerial renegotiation
of contracts explains why the IPO premium is always followed by a discount. Wermers,
Wu & Zechner (2008) provide support for Berk & Stanton’s conjecture that new man-
agers earn substantial excess NAV returns. Strong empirical support for the CSS and Berk &
Stanton models comes from hedge fund data. Ramadorai (2012) observes that hedge funds
have many CEF-like characteristics (also see Ang & Bollen 2010), including lock-up
periods, investors’ ability to trade the locked-up shares in secondary over-the-counter mar-
kets (where their prices exhibit premium/discount patterns akin to that observed in CEFs).
Hedge funds also offer a clear advantage when it comes to measuring the skills of hedge
fund managers. Ramadorai (2012) utilizes a unique data set from Hedgebay (for 1998–2008)
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to show that managerial skills, managerial compensation, and the liquidity of shares are
statistically significant factors in explaining patterns of premiums; i.e., the Berk & Stanton
and CSS models’ predictions are borne out by data.
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2.4. Other Discount Theories

There are several other discount theories (in addition to two above-mentioned) that try
to explain all or part of the phenomena. I review them in order of their relative importance
in the literature.

2.4.1. Tax overhang. Managers of a mutual fund realize capital gains at times that are
not necessarily optimal to an individual investor. In other words, investing in a mutual fund
takes away the investors’ tax-timing option, the loss of which makes a fund with accu-
mulated capital gains less attractive to investors. A subset of the literature tests empiri-
cally whether this is the source of CEF discounts at funds with unrealized capital gains
(the so-called tax overhang). Malkiel (1977) finds that CEF discounts are positively
correlated with unrealized capital gains. Brickley, Manaster & Schallheim (1991);
Elton, Gruber & Blake (2005); Chay, Choi & Pontiff (2006); Brennan & Jain (2007);
and more recently Day, Li & Xu (2011)6 find support for the unrealized capital gains
hypothesis. Chay, Choi & Pontiff calculate that each dollar of distributed capital gains
shrinks the discount by 7¢.
Although there is no arguing with empirical results, one can argue with the authors’
interpretation: The loss of the capital gain timing option makes a fund with accumulated
capital gains less attractive to new investors, and an OEF manager has an incentive to
realize capital gains by sacrificing the well-being of old investors for inflows from new
investors (see Musto 2011). But in the CEF case, no new money flows into a fund (rights
offering is not considered), and realizing capital gains shrinks the base of managerial
compensation. So CEF managers have an incentive to postpone this realization for as
long as possible. These considerations make me suspicious about the interpretation of the
empirical facts presented in the above-mentioned literature. For an alternative interpre-
tation, please see Cherkes, Sagi & Wang (2011).

6
Day, Li & Xu’s support is limited to short-term fluctuations in discount; for the long run, they find the opposite
results for the relationship between accumulated capital gains and discount.

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Closed-End Funds: A Survey 437

 2.4.2. Bookkeeping issues. Malkiel (1977) hypothesizes that the reported NAV may
actually be different from the mark-to-market NAV due to any number of bookkeeping
complications. Brauer (1984) and Brickley & Schallheim (1985) lay to rest this concern.
They analyze CEFs that had been terminated or converted to OEFs. Some of these CEFs
traded at sizable discounts prior to termination, yet converged to NAV at termination—the
best proof that discounts are a real phenomenon and not a result of faulty bookkeeping.

2.4.3. Market segmentation. Market segmentation as a source of CEF premiums has been
analyzed, starting with Bonser-Neal et al. (1990). The most popular area of this research
is international market segmentation. Here is how it works: Consider a US investor who
has limited options to invest in country X. A CEF specializing in shares of X (the so-called
country fund) is then one of only a few available venues—therefore, it could trade at a
premium to its NAV. Bonser-Neal et al. (1990) find empirical support for the segregated
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markets hypothesis. Their result is supported by current work by Kim & Song (2010) but
is rejected by Patro (2005), who revisits the issue using a much larger sample but finds
no proof for the hypothesis. (Also see Froot & Ramadorai 2008.)
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A related question deals with the relationship between a country fund’s premium and
the degree of its portfolio diversification. Bekaert & Urias (1996) provide support for the
hypothesis that wider diversification decreases the size of the CEF discount (and increases
the size of the premium) in emerging-market CEFs.

2.4.4. Provision of leverage. Every mutual fund provides diverse services. CEFs are distinct
from OEFs in provision of leverage. Elton et al. (2012) utilize a large sample of bond CEFs
to show that, when compared with OEFs, their performance depends crucially on leverage:
The higher the leverage is, the better the fund’s performance will be. They also compare
OEFs and CEFs managed by the same portfolio manager and find that leverage, rather than
liquidity, is the only distinct dimension. They claim that CEFs’ ability to borrow is the reason
for CEFs’ existence—at least among bond funds. The importance of leverage in explaining
CEF premiums is supported by CSS (2009) and Ramadorai (2012), who find that an
increase in the short-term interest rate has a large negative impact on CEF premiums.

2.4.5. Other models. Spiegel (1999) shows that, even in a frictionless production economy,
the price of a CEF need not track its NAV.

3. WHAT DEFINES THE CHOICE OF ORGANIZATIONAL FORM?

Although professional fund managers decide which new fund, OEF or CEF, to offer, their
decisions are driven by investors’ demand. Stein (2005) postulates that demand is guided
by a trade-off between CEFs’ ability to implement long-term investment strategies7 with-
out risk of a withdrawal run and agency issues that are endemic to CEFs. Stein shows that
all-CEF equilibrium is not necessarily stable because more capable managers always have
an incentive to signal their ability by offering an OEF; the resulting equilibrium may
produce a less-than-optimal number of CEFs. And, indeed, between the launch of the

7
As an example of a long-term strategy, consider CEFs’ ability to employ trend-bending investments away from
dot-com stocks during the dot-com bubble or their ability to invest a large share of their funds in illiquid assets,
as REITs do.

438 Cherkes
 first US CEF in 1889 and the late 1940s, CEFs were more numerous and managed more
assets (Close 1951) than did the later arrivals, OEFs. Today there are 25 times as many
OEFs than CEFs, and the OEFs manage 50 times as many assets (see ICI 2011).
Stein (2005) conjectures that CEFs’ main advantage is their ability to implement long-
term strategies; it is supported by the fact that CEFs concentrate their holdings at the
less-liquid part of the liquidity spectrum. However, CEFs do more than hold illiquid
assets: They transform illiquid holdings into liquid securities, thereby generating value to
balance the losses due to agency costs. This may be the economic rationale for the exis-
tence of CEFs: They transform illiquid assets that are costly to acquire at a retail level
into liquid securities that are cheap to acquire at a retail level, thereby facilitating small
investors.8 If the value added by transformation is larger than the direct and indirect
agency costs, the fund will trade at a premium. This transformation-of-liquidity hypothesis
clearly describes the application of CEFs as an organizational form to situations in which
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it is cheaper (including managerial fees) to trade via the fund than directly.
Several testable conjectures can be taken from this observation. First, small investors’
demand for investments in illiquid assets defines the size of the pool of assets under CEFs’
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management. Second, CEF managers develop expertise in managing and trading illiquid
assets. Third, this skill is reflected in both the holdings and the discount of a fund.
Elton et al. (2012) offer a version of this theory in which the liquidity transformation is
replaced by leverage provision.
Another reason for CEFs’ existence may be managers’ expertise in the provision of
liquidity that allows collection of a liquidity premium—a version of the Berk & Stanton
(2007) model. All these ideas can be brought together under a single theory that concen-
trates on the provision of unique services as a reason for opening a new CEF.
The other theory to explain CEFs’ raison d’être is the marketing hypothesis, which
postulates that the issuance of new CEFs is simply a rent-extraction tool. Professional
managers exploit the presence of naı̈ve investors to sell them new CEFs; these managers
then manage the funds and collect rents9 (see LST 1991 and Hanley, Lee & Seguin 1996).
The marketing hypothesis is supported by Barclay, Holderness & Pontiff’s (1993) finding
that block-holders extract private benefits through managing CEFs and by Deli’s (2002)
finding that (on margin) CEF advisors receive higher marginal compensation than do OEF
advisors. There are several works (e.g., Khorana, Wahal & Zenner 2002 and Del Guercio,
Dann & Partch 2003) that connect the size of managerial fees to the size and composition
of the CEF board; these works can be interpreted as supporting the marketing hypothesis,
but they do not imply systematic rent extraction. As always, both motifs (efficiency and
managerial opportunism) may be present in the data, but the question of which motif
is prevalent still has to be answered.

4. THE RESOLUTION OF THE IPO PUZZLE

Every new CEF is initiated by a professional fund manager, who utilizes underwriting
services to list the fund on an exchange and to raise funds. The Initial Public Offering

8
The point is not the identity of investors but the size of purchases, which is small—most of the deals are below $10 K.
In the UK, most of the investors are institutions, not individuals. But these are small pension funds, and it would
be costly for them to properly diversify their holdings if they were to buy securities directly rather than via a fund.
9
In other words, CEFs’ raison d’être is rooted in market inefficiency.

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Closed-End Funds: A Survey 439

 (IPO) process itself is costly and complicated. Hanley, Kumar & Seguin (1993) document
extensive price support for the new shares, and Hanley, Lee & Seguin (1996) show that
CEF IPOs do not exhibit typical underpricing.
The underwriting fee is paid out of IPO proceeds, with the balance becoming the
new fund’s NAV. In other words, the CEF has to be brought to the market at a premium.
LST (1991) observe that most existing (seasoned) funds trade usually at a discount and
that new CEFs converge to discount quickly.10 They conclude that “[i]t seems necessary
to introduce some type of irrational investor to be able to explain why anyone buys the
fund shares. . . [at IPO]” while existing CEFs trade at a discount (LST 1991, p. 84).
To test this point, CSS (2009) investigate a strategy that consists of long, seasoned funds
(more than one year old) and short, unseasoned funds (less than one year old). If LST
(1991) are right, this strategy should generate abnormally large profits. Yet CSS find that
small underperformance (0.3% per month) of unseasoned funds exists only in two sectors,
Annu. Rev. Fin. Econ. 2012.4:431-445. Downloaded from www.annualreviews.org

municipal bonds and taxable fixed income. The above calculation does not consider trad-
ing cost, savings on brokerage when buying at IPO, and costs of running a short position
for a year, which indicates that there are no arbitrage opportunities.
by Columbia University on 11/01/12. For personal use only.

5. CLOSED-END FUNDS AS A LABORATORY FOR

CORPORATE FINANCE
CEF shares and CEF holdings are securities that trade contemporaneously on exchanges,
so calculation of a CEF’s Tobin’s q is straightforward. CEF managerial costs are fully
reported, and any change in these costs can be traced. Compulsory reporting of infor-
mation allows one to observe changes both in asset composition and in the market price
of the fund, which opens a venue for natural experiments. These features are unique in
corporate finance and make CEFs an ideal framework in which to investigate questions
about managerial incentives, optimal structures of boards, the potency of dividend policy,
the impact of proxy fights on valuation of the firm, etc. Below I list roughly a dozen articles
that use the unique position of CEFs to test corporate finance theories.
For example, the corporate finance literature deals with the optimal design of a corpo-
rate board with regard to its size and the relative weight of inside versus outside directors
(see Adams, Hermalin & Weisbach 2010). Differences in the size and complexity of
commercial firms preclude a clear-cut answer to these questions. However, CEFs are
relatively homogeneous in terms of size and complexity, so they are an ideal framework
in which to explore these issues. Del Guercio, Dann & Partch (2003) and Gemmill &
Thomas (2006) use, respectively, large US and UK samples and conclude that “funds with
relatively low expense ratios, one measure of board effectiveness, have smaller boards,
a higher proportion of board members who are legally considered independent, [and a]
relatively low director compensation (Del Guercio, Dann & Partch 2003, p.111).”
An interesting test of the theory of optimal directorial compensation is discussed by
Zhao (2011). The theory predicts that greater directorial ownership should have beneficial
effects on a fund’s performance and, therefore, on the fund’s valuation. A natural experi-
ment allows one to test this conjecture directly: In 2001, the SEC issued an order requiring
all fund directors to reveal, by the end of January 2002, their ownership in the funds

10
Weiss (1989) finds that the average time from IPO to discount is 100 days. CSS (2009) use a larger sample to find
that it takes, on average, 12 months for a new fund to trade at a discount.

440 Cherkes
 that they serve. This information had previously been private and became public after
February 2002. Indeed, Zhao (2011) finds that after January 2002, the new information
had a differentiated effect on CEF discounts: A revelation of greater directorial ownership
caused CEF discounts to shrink more than the theory predicted.
The importance and efficacy of payout policy are another central issue in corporate
finance theory. Since Pontiff (1996), we have known that higher payouts correlate with
higher CEF share prices and lower discounts—a phenomenon akin to the effect of payout
increase on a commercial firm’s share price. The corporate finance theory has no clear
explanation for the latter phenomenon (see Allen & Michaely 2003). The dominant
theory is the so-called signaling hypothesis, which interprets the increase in corporate
payouts as a signal of future superior corporate performance. CEFs provide an oppor-
tunity to test this hypothesis: Many equity CEFs adopt MDPs, which are commitments
for enhanced future dividends. Adoption of MDPs increases the price of CEF shares and
Annu. Rev. Fin. Econ. 2012.4:431-445. Downloaded from www.annualreviews.org

shrinks the discount, as was first documented by Wang (2004) and Johnson, Lin & Song
(2006). The latter authors find support for the signaling hypothesis, whereas Wang &
Nanda (2011) and Cherkes, Sagi & Wang (2011) reject it. Cherkes, Sagi & Wang offer
by Columbia University on 11/01/12. For personal use only.

an alternative explanation to potency of CEF dividend policy: They show that an MDP
decreases the managerial compensation; the capitalized value of savings on managerial
compensation is reflected in CEF share price.
An, Gemmill & Thomas (2012) analyze another form of payout, namely stock
repurchases, in UK CEFs. They find that repurchases have an immediate but small effect
on CEF price and a long-term, larger effect on CEF performance. They explain the former
effect via accounting gains due to repurchase at prices below NAV, and they attribute the
latter effect to the disciplinary effects of repurchase on managerial pay, not signaling.
Several studies explore the ex-dividend behavior of CEF prices. Elton, Gruber & Blake
(2005) investigate why stock prices on ex-dividend days decline by less than the dividend
paid; they use taxable versus nontaxable CEFs to conclude that this finding is indeed
consistent with tax effects. A related study supports the January effect as a tax-related issue
(see Starks, Yong & Zheng 2006).
Hedge funds’ and raiders’ activism is a bone of contention in corporate finance litera-
ture (see Brav, Jiang & Kim 2009). In particular, there is no agreement concerning the
potency of activist attacks and of proxy fights. CEFs provide an ideal arena in which to test
alternative hypotheses, given the large number of attacks; the observability of the funds’
holdings; and their market valuation before and after an activist attack. Bradley et al.
(2010) and Cherkes, Sagi & Wang (2011) explore the results of activist attacks/ proxy
fights on equity CEFs. Both articles find that proxy fights have a large positive effect on
CEFs’ discounts even when the proxy fight itself fails. Cherkes, Sagi & Wang (2011) model
the proxy fight as an interplay between managers and activists. Their model and empiri-
cal findings explain the efficacy of attacks via managerial decision to forego some of its
compensation to preserve their on-job tenure.
Two more papers worth mentioning are as follows. Gemmill (2001) offers an interest-
ing test of the Miller-Modigliani theory: He utilizes the fact that some UK CEFs are
organized as so-called split-capital funds to show that the presence of differential taxes
and clienteles substantially influences valuation of a firm. Coles, Suay & Woodbury (2000)
deal with issues of managerial pay and its impact on firms’ performance; they find that
even large managerial incentives cannot increase substantially the closed-end fund’s per-
formance; thus, “for the average fund, ceteris paribus, an increase of . . . managerial

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Closed-End Funds: A Survey 441

 compensation . . .by one standard deviation (which would increase managerial fee by
50%!) . . . would increase the premium from 5.8% to 4.4%” (Coles, Suay & Woodbury
2000, p. 1401).

6. CONCLUSION
Historically, CEFs have gone in and out of fashion and were issued in waves separated by
long periods of inactivity. For example, 1929 was one of the wave years: More than 40 new
CEFs were issued in September 1929 alone (see De Long & Shleifer 1990, figure 4), but no
new funds were issued in November 1929. With very few exceptions, no new CEFs were
issued until the mid-1980s, when there were only a few dozen CEFs in existence—mainly
survivors from the 1929 period (such as the Tri-Continental Corporation, which was
issued in August 1929). Then, between 1986 and 2000 a total of 538 CEFs were IPOed
Annu. Rev. Fin. Econ. 2012.4:431-445. Downloaded from www.annualreviews.org

(Cherkes 2003). Since then, new issuances have become as common as liquidations of
existing CEFs; the total numbers have not changed much.
It is my belief that CEFs are here to stay and that new waves will continue to arrive
by Columbia University on 11/01/12. For personal use only.

because CEFs are an important organizational form; they will be utilized when relative
liquidity is an issue, leverage (or credit) is an issue, and the need for large investment in
human and other capital in fund management is an issue. To wit, see the burgeoning
REIT industry and the arrival of exchange-traded funds (Huang & Guedj 2009). I also
believe that financial economists will continue to utilize the transparency and availability
of CEF data for new inquiries into the theory of the firm, because CEFs are the simplest
type of firm.

DISCLOSURE STATEMENT
The author is not aware of any affiliations, memberships, funding, or financial holdings
that might be perceived as affecting the objectivity of this review.

ACKNOWLEDGMENTS
This work benefited tremendously from discussions with Franklin Allen, Charles Calomiris,
Burton Malkiel, Jeffrey Pontiff, Jacob Sagi, and Chester Spatt. I gratefully acknowledge
helpful comments from Yakov Amihud, Jacob Boudoukh, Michael Brennan, Wei Jiang,
Gordon Gemmill, Itay Goldstein, Martin Gruber, David Musto, Tarun Ramadorai, Matthew
Spiegel, Dylan Thomas, Jay Wang, and Daniel Wolfenzon. Lastly, I want to thank the
anonymous referee for insightful comments and helpful suggestions.

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 Annual Review of
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Contents Volume 4, 2012

Implications of the Dodd-Frank Act

Viral V. Acharya and Matthew Richardson. . . . . . . . . . . . . . . . . . . . . . . . . 1
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Valuation of Government Policies and Projects

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The Impacts of Automation and High Frequency Trading

on Market Quality
Robert Litzenberger, Jeff Castura, and Richard Gorelick . . . . . . . . . . . . . 59
Shadow Banking Regulation
Tobias Adrian and Adam B. Ashcraft . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
Narrow Banking
George Pennacchi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Federal Reserve Liquidity Provision during the Financial Crisis
of 2007–2009
Michael J. Fleming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Efficient Markets and the Law: A Predictable Past
and an Uncertain Future
Henry T.C. Hu . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Corporate Governance of Financial Institutions
Hamid Mehran and Lindsay Mollineaux . . . . . . . . . . . . . . . . . . . . . . . . 215
Corporate Finance and Financial Institutions
Mark J. Flannery. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
A Survey of Systemic Risk Analytics
Dimitrios Bisias, Mark Flood, Andrew W. Lo,
and Stavros Valavanis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
Sovereign and Financial-Sector Risk: Measurement and Interactions
Dale F. Gray and Samuel W. Malone . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

vii
 Regime Changes and Financial Markets
Andrew Ang and Allan Timmermann . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
The Real Effects of Financial Markets
Philip Bond, Alex Edmans, and Itay Goldstein. . . . . . . . . . . . . . . . . . . . 339
Economic Activity of Firms and Asset Prices
Leonid Kogan and Dimitris Papanikolaou . . . . . . . . . . . . . . . . . . . . . . . 361
Consumption-Based Asset Pricing Models
Rajnish Mehra . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
Taxes and Investment Choice
Robert M. Dammon and Chester S. Spatt. . . . . . . . . . . . . . . . . . . . . . . . 411
Annu. Rev. Fin. Econ. 2012.4:431-445. Downloaded from www.annualreviews.org

Closed-End Funds: A Survey

Martin Cherkes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
by Columbia University on 11/01/12. For personal use only.

Commodity Investing
K. Geert Rouwenhorst and Ke Tang . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
Market Microstructure and the Profitability of Currency Trading
Carol Osler. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469

Errata
An online log of corrections to Annual Review of Financial Economics
articles may be found at http://financial.annualreviews.org

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