The closed-end puzzle illustrates opaque framing, heuristic-driven bias, and an inefficient market—in short, all three themes in behavioral finance. The chief feature of the puzzle is that closed-end fund prices systematically deviate from fundamental values. In this respect, fundamental value is measured by net asset value (NAV), which is defined as the per-share market value of the securities in the closed-end fund portfolio.
Because fund shares trade on organized exchanges, just like the shares of corporations, the market value of the closed-end fund shares may differ from NAV. When the market value of closed-end fund shares exceeds NAV, the shares are said to trade at a premium. If market value is less, the shares trade at a discount.
Money magazine’s Wall Street correspondent, Jordan Goodman, suggests that fixing the number of shares offers closed-end funds managers the opportunity to make investment decisions without the distraction of dealing with purchases and redemptions faced by their open-end mutual fund counterparts. This brings us to the point about closed-end funds being a puzzle, as well as an embarrassment. The puzzle is that closed-end funds often trade at values quite different from NAV. The embarrassment, at least to fund managers and fund boards, is that the funds trade at discounts more often than not.
This chapter discusses the following:
• a case illustrating the movement of discounts over time
• the four parts of the closed-end fund puzzle
• sentiment as an explanation of the closed-end fund puzzle
• the impact of heuristic-driven bias on the prices of country funds
• how dividends affect discounts on closed-end funds
Case Study: Nuveen Closed-End Bond Funds
John R. Nuveen and Company is a major financial firm specializing in municipal bonds.1 The November 29, 1993, issue of Barron’s reports that in that year, Nuveen accounted for approximately 42 percent of the $45 billion municipal bond closed-end fund market.2 In April 1998 Nuveen managed fifty-seven different closed-end funds. Among them is the Nuveen Premium Income Municipal Fund (NPI), which is a national fund, meaning that it holds municipal bonds from a variety of states. The key attraction of these bonds is that the interest the bonds pay is not subject to federal income tax.
Consider the behavior of NPI shares between July 1988 and July 1992. As figure 13-1 illustrates, the price of NPI started out at $15 a share, declined to $14 shortly thereafter, and rose to $17.25 by July 1992. This represented an 8 percent annual return over those four years.
An important factor driving these returns was the general movement of interest rates. In August 1988 the ten-year Treasury bond was trading at 8.64 percent. The rate rose to 9.32 percent in February 1989 and then began to decline, eventually falling to 6.71 percent at the end of July 1992.
Looking at figure 13-1, we can see that the share price of NPI rose dramatically from early 1990 through midyear 1992. Investors who bought NPI shares in February 1990 would have earned 14.36 percent per year by the end of July 1992. But had they bought at the end of May 1992, investors would have earned a remarkable 31.8 percent per year over the next two months!
In August 1992, Nuveen introduced a new closed-end fund, Nuveen Premium Income Municipal Fund 2 (NPM). The history of NPM illustrates some of the key features associated with closed-end funds.
Figure 13-1 Share Price, NPI, July 1988–July 1992
How the price of Nuveen Premium Income Municipal Fund (NPI) performed between its introduction in 1988, at a price of $15, and July 1992. Shortly after its introduction, the price declined below $15 for several months.
First, the environment was positive for mutual funds. Interest rates were falling, and municipal bond funds were earning high returns. Investor sentiment appeared quite positive. NPM began trading on August 17, 1992, at $15 per share. This represented a premium of 6.8 percent, relative to NAV.
Figure 13-2 traces out the behavior of the NPM share price between August 1992 and March 1998. Notice how similar figures 13-1 and 13-2 are to each other. The shares of both funds trade around their initial offer prices, decline below the offer price within the first few months, and then rise through time. As we shall see, this pattern is typical of many closed-end funds.
The time frame depicted in figure 13-2 was a very interesting period. Let’s start with the period through December 1993. After initially trading at $15, the price of NPM fell to $13 and then rose back to $15 as 1993 progressed.3 As can be seen from the figure, NPM shares started to fall dramatically in November 1993, in reaction to general interest rate movements. The Treasury bill rate had fallen below 3 percent in September 1993. But because of Federal Reserve Board policy, it rose to 3.2 percent in November.
At the start of 1994, the price of NPM stood at $14.12. This represented a 9.2 percent discount. In early January, an article titled “Quarterly Mutual Funds Review: Closed-end Bond Funds Look Cheap” appeared in the Wall Street Journal. The article described the general environment for municipal bond funds, and began as follows:
Department stores aren’t the only place for after-Christmas sales. Bargains also beckon in publicly traded bond funds.
“There are lots of bargains around in such funds,” says Thomas Herzfeld, president of Thomas Herzfeld Advisors, a Miami firm specializing in publicly traded mutual funds. “This is hunting season for closed-end bond funds.” Among Mr. Herzfeld’s favorites are Nuveen Insured Premium Income Municipal 2 and Nuveen Premium Income Municipal 4, currently at discounts of 7.6% and 9.7%, respectively. These tax-exempt bond funds came to market last year at $15 a share—a 6.8% premium—and now trade at about $13 a share. Their assets, meanwhile, have edged up in value, and should continue to gain on rising investor demand as the tax season approaches, he says. Of course, the outlook for interest rates may justify bond funds’ discounts, and there’s no guarantee their cheap prices won’t get even cheaper in the future. The apparent bargains may accurately reflect real risks lurking in these funds, some analysts say.4
Figure 13-2 makes it dramatically clear that in hindsight, “some analysts” turned out to be right. The Federal Reserve Board was about to hike interest rates seven times in twelve months. By October 22, the price of NPM had dropped to $11.50, and its discount had gone to 13.8 percent.
Figure 13-2 Share Price, NPM
How the price of Nuveen Premium Income Municipal Fund 2 (NPM) performed between its introduction in August 1992, at a price of$15, and March 1998. Shortly after its introduction, the price declined below $15 for several years.
Over the next two years, the discount gradually narrowed. On February 23, 1996, it stood at 7 percent. On July 11, 1997, it was down to 4.1 percent. In 1998, much to the relief of the fund board, NPM was again trading at a premium—0.4 percent.
The General Phenomenon: A Puzzle in Four Parts
The experience of NPM relative to other closed-end funds is quite typical. Charles Lee, Andrei Shleifer, and Richard Thaler (1991) describe what they call the closed-end fund puzzle. The puzzle has four parts.
1. The average closed-end fund is initially priced at a premium of 10 percent.
2. Within 120 days of being brought out, the average fund is trading at a discount of 10 percent.
3. The magnitude of the discount is not stable; it varies through time.
4. When a closed-end fund is either liquidated or converted into an open-end fund, the share price tends to rise and the discount tends to shrink.
How can we explain the closed-end fund puzzle? Let’s begin with the first part of the puzzle.
Part 1: The experience of Nuveen closed-end funds provides some insight. Nuveen sells its funds to individual investors through adviser-based channels. Investors who rely on advisers tend to have limited knowledge about financial matters. Investors with limited knowledge would typically trade securities through a full-fee broker, for example, rather than use a discount broker who provides no advice. Naturally, investors pay more through full-fee brokers than they do through discount brokers, wit
h the difference in fee representing the value of the counseling services and advice. Essentially, the same issue applies to the initial offering of a closed-end fund. These funds carry an up-front “load.” However, as Bary explained, these funds are framed as being “no-load”—a clear instance of frame dependence. Bary writes:
While many brokers will say new closed-end funds are “commission-free,” the reality is quite different. Rather than the broker charging the investor directly, the commissions, typically totaling 6%–7%, are deducted from the fund proceeds.
A fund that comes to market, for instance, at 15 will typically start with just $14 in assets. After an initial period during which underwriters support the stock price, the closed-end funds tend to drop down to their NAVs. Because of the tendency of new funds to erode in price, many pros advise investors to stick with older issues.5
Part 2: Kathleen Weiss Hanley, Charles Lee, and Paul Seguin (1996) also make the preceding point. They suggest that the fund manager will usually support the fund price in the market for a short while after the offering and then reduce that support gradually to mask the nature of the initial premium. This explains why the premium tends to be transformed into a discount within the first 120 days.
Part 3: But the removal of support does not explain why funds typically trade at a discount. Lee, Shleifer, and Thaler (1991) suggest that the explanation involves investor sentiment. Pessimism drives up the magnitude of the discount.
In a 1993 Forbes magazine article, Mary Beth Grover recommended that smart investors not purchase closed-end funds when they are initially offered, but instead purchase those funds when they already trade at a discount. She stated:
When your broker calls, flogging initial public offerings of closed-end funds at a cut rate, don’t bite. With the public appetite for equities and bonds voracious, marketers of closed-end funds are churning out initial public offerings like never before. The total of newborn closed-ends this year will be in the neighborhood of $17 billion, according to Newark, N.J.–based Securities Data Co. That’s a trebling in three years. When Wall Street is pushing anything this strongly, investors need to be skeptical. The closed-end boom is a case in point. There are thousands of mutual funds that can be bought at net asset value and dozens of existing closed-end trusts selling at discounts. So why pay a premium of 6% or 7% in brokerage commissions to buy a newly minted fund? (Grover 1993)
Notice Grover’s statement about sentiment, namely that “marketers of closed-end funds churn out those funds when the “public appetite” is “voracious.” Smart investors will wait to purchase these funds until the funds move to a discount. However, as we saw with the discount on Nuveen’s NPM fund, the magnitude of the discount has been quite variable over time. This illustrates the third part of the puzzle, that investor appetites are more voracious at some times than others. So even sophisticated investors face risk when buying at a discount. In fact, closed-end funds may need to trade at a discount most of the time, in order to compensate smart investors for the risks associated with holding these funds.
Bary makes a similar point in his Barron’s article dealing with municipal bond closed-end funds:
After several years as one of the hottest investments, closed-end municipal bond funds have gone cold lately. …
[I]ssuance of new funds has virtually ground to a halt after running at a quarterly pace of more than $2 billion up until mid-year. Through Friday, just four funds, totaling $200 million, had come to market since the start of the fourth quarter.
More important for investors, prices of most funds have come under pressure lately, with some declining 10% or more since the start of November.
“The Wall Street underwriters have been relentless in bringing new funds to market,” says Thomas Herzfeld, president of Thomas Herzfeld Advisors, a Miami firm specializing in closed-end funds. “They and the fund managers got greedy and they brought clone after clone to market. There’s simply a glut.” …
It had gotten to the point where the market was seeing not only clone funds, but also clones of clones of clones. John Nuveen, for instance, has offered six different funds called Nuveen Premium Income Municipal Fund. The like-sounding names make it tough even for pros to keep the funds straight.
Several other factors contributed to the recent losses in the $45 billion market, most notably the recent spike in interest rates.6
According to Lee, Shleifer, and Thaler, discounts on closed-end funds as a whole serve as a sentiment index. The widening of premiums signals investor optimism, and the widening of discounts signals investor pessimism. As a general matter, the discount on any particular fund may reflect something specific to that fund, rather than overall investor sentiment. Yet the discount on Nuveen’s NPM fund did track the average discount on national municipal bond funds quite closely. Table 13-1 illustrates the point, for key dates between August 1992 and January 1998.
When NPM went public in August 1992, the average discount for national municipal bond funds was 1 percent. In October 1994, when
Table 13-1 Co-Movement of Discount on NPM and Average Discount on National Municipal Bond Funds
the discount on NPM was near 14 percent, the average national municipal bond fund was trading at a discount of about 10 percent. In January 1998 both NPM and the average fund were trading at premiums of less than 1 percent.
Part 4: The fourth part of the closed-end fund puzzle involves the fact that the discount narrows when the fund is either liquidated or converted into an open-end fund. In itself, this is not surprising. However, what is surprising is that investors in closed-end funds that do trade at deep discounts have been reluctant to push forcibly to have those funds opened up. This manifestation of investor inertia was described in a May 1997 Los Angeles Times article.
When open-ending provisions come up for a vote, many investors fail to cast ballots or blindly check off the actions recommended by the directors. It doesn’t help that funds routinely require “supermajority” approval of open-ending proposals, mandating a “yes” vote by anywhere from 67% to 80% of outstanding shares.
John M. Cunningham, an investment advisor in Wayne, Pa., was among a group of investors who in March tried unsuccessfully to convert the closed-end Templeton Global Income Fund into an open-end portfolio. “Some of my own clients didn’t even act on the proposal; they didn’t even read the proxy materials to notice that my name was in there,” he said. “That’s how uninterested some people are.”7
Is There Learning?
Over time, the public’s appetite for new closed-end funds did wane. In 1996, only four new closed-end funds were brought to market, down from 126 three years earlier. Investors began to learn, as did the sponsors and syndicates that bring out the funds and sell them.
After 1994, sponsors began putting more effort into understanding the biases and framing issues affecting investors. Individual investors are subject to extrapolation bias, meaning they bet on trends. During a period of rising interest rates, investors become unduly pessimistic about the prospects for closed-end bond funds.
Fund sponsors like Nuveen began to realize that investors had a very poor understanding of how closed-end bond funds work. During the 1980s and early 1990s, investors had successfully bet on a trend. But they did not understand that interest rates move in cycles. So, after their experience in 1994, investors began to bet that the future trend would be down.
In the face of this pessimism, the closed-end fund “universe” came to realize the need for investor hand-holding—education, explanation, and consolation. And it had an effect on some parts of the closed-end fund puzzle. The “load framed as a no-load” strategy for initial public offerings of closed-end bond funds has disappeared. Now the sponsor bears all the initial expenses, covering the investment house concession fee and brokerage commissions, and recouping through future fees.
Nevertheless, despite the innovations of sponsors, the puzzle is still with us. For example, in order to address investors’ growing reluctance
to pay an initial premium and watch it turn into a discount shortly thereafter, one fund tried a new twist. The Dessauer Global Equity Fund, which was introduced in May 1997, stated in its prospectus that after eighteen months, if its shares trade at a discount of 5 percent or more for fifteen straight days, then the fund will convert to open-end format. Such a conversion, however, is not likely since enough investors understand that the fund trades at net asset value when opened. Hence, they would start to purchase shares in the fund at the five percent discount, as the fifteen day period ended, thereby causing the discount to fall below five percent.
So how did the discount on the Dessauer Global Equity Fund behave in practice? When it was first offered on May 30, 1997, at $12.50 a share, the fund traded at a 5 percent premium. By October 1997, the premium had fallen to 2 percent, and at year-end 1997 the fund was trading at a 16 percent discount. For the first ten months of 1998, the discount averaged 7.8 percent. And what happened as the eighteen-month horizon approached? Between October 9 and November 13, 1998, the fund’s discount fluctuated between 8.3 percent and 16.7 percent. As the end of the horizon approached on December 1, the discount fell back to 8.5 percent. On February 26, 1999, it was 6.2 percent.
Sentiment
One of the most intriguing aspects of the argument by Lee, Shleifer, and Thaler (1991) is that the discounts on closed-end funds serve as an indicator of individual investors’ sentiment. They point out that over 90 percent of closed-end fund shares are held by individual investors, suggesting that the narrowing of discounts reflects increased optimism on the part of these investors.
Interestingly, small stocks too are largely held by individuals rather than institutions. For instance, about 75 percent of the smallest firms (lowest decile) are held by individuals. The return to small stocks should go up, on average, when individual investors become more optimistic. If closed-end fund discounts serve as an indicator of sentiment, then a narrowing of these discounts should occur together with an increase in the return to small stocks. In fact, that is what Lee, Shleifer, and Thaler find.
Beyond Greed and Fear Page 24