19). Nevertheless the US and the UK markets are more similar than different, that is why we can extend results acquired from one market to another, but with some corrections made. This paper consists of two parts. The first part provides an explanation for the closed-end fund puzzle from the behavioral perspective. The second part deals with further tests, which can be used to verify the investor sentiment explanation.
Unlike economic theories trying to explain the closed-end fund puzzle with rational assumptions (e.g. tax liabilities), behavioral theories imply that there is some amount of irrationality on the market. It is called "noise trader sentiment" - the component of expectations about asset returns not warranted by fundamentals.
Basic assumptions of investor sentiment explanations are as follows:some of the investors are not fully rational, and their demand for risky assets is affected by their beliefs or sentiments; arbitrage is risky and therefore limited. However, researchers advise not to fall into opposite extreme: "It is absolutely not true that introducing a degree of irrationality of some investors into models of financial markets eliminates all discipline and can explain everything" (Shleifer and Summers 1990, pp. 19-20). Thus a moderate approach should be implemented.
Closed-end fund puzzle is often divided into four parts:
1. Trusts are typically launched at a premium of almost 10%.
2. Trusts typically soon move to a discount, although some funds do at times trade at a small premium.
3. Discounts fluctuate widely over the life of a fund.
4. Upon termination, discounts narrow as the share price rises to meet NAV. (Lee et al 1991, pp. 76-77)
Let us observe each of these issues from the sentiment perspective.
Traditionally, premium is supposed to be strongly connected to returns. "Premia have an economically strong ability to predict returns" (Pontiff 1995, p. 366). However, at a start of a closed-end fund there is little can be said about returns, but most of them are launched at a premium of 5-10%. How can we explain it
Behavioral theory assumes that entrepreneurs gain profit from selling their assets gathered in a closed-end fund to noise traders, which are baselessly optimistic about returns. "It seems necessary to introduce some type of irrational investor to explain why anyone buys the fund shares at the start when the expected return over the next few months is negative" (Lee et al 1991, p. 84). This theory argues that there is no efficiency reason explaining that part of the puzzle.
The main issue of the closed-end fund is moving to a discount after a short time period. Investor sentiment theory implies that holding the fund entails larger risks than holding its portfolio:
The evidence that funds, on average, sell at a discount does not rely on the average pessimism of noise traders, but stems completely from the risk aversion of rational investors who are willing to buy closed-end fund shares only if they are compensated for the noise trader risk, which means buying the fund at a discount. (Dimson and Minio-Kozerski 1999, pp. 19-20)
However, some researchers have doubts about the fact that investor sentiment is able to explain discounts. For example Busse et al suggests that the reason lies in the managerial performance rather than in