Insight Line—June 11, 2007

A longstanding debate in closed end fund investing is whether the funds’ market pricing reflects rationality on the part of investors. In other words, if the market is efficient, why do some closed end funds seem to trade in the market at a persistent discount to their net asset values (NAVs)?

Needless to say, such a question has spawned all manner of white paper analyses, from the eloquent to the mathematically incomprehensible (at least to me). Unfortunately, best efforts aside, drawing a consensus has been but a distant consideration. For every rational explanation thought to be the cause, including management skill, underlying portfolio liquidity or taxes, researchers cited exceptions to negate the theory. It wasn’t until 1990 that researchers began to address the persistence of closed end fund discounts in an entirely different light. In that year, Charles Lee, Andrei Shleifer, and Richard Thaler¹ refocused the debate in terms of human behavior after comprehensively reviewing and debunking the prevailing academic rationale at the time. Simply put, at least to Lee, Shleifer and Thaler, the share prices of closed end funds is essentially a popularity contest—with investors as the judges. As borne out by their research and as follow-on research attests, a closed end fund’s share price is not solely dependent upon the underlying movement in the NAV.

This reasoning opened up an entirely different investment question for researchers to theorize. If the pricing of closed end funds is behaviorally driven (a popularity contest if you will) does then the discount (or premium) to NAV serve as a metric from which to speculate on subsequent market share price movement?

Here again, the academic world is less than cohesive in their response. Burton Malkiel, the noted efficient market advocate and author of A Random Walk Down Wall Street,² along with his co-researcher Yexiau Xu, finds the discount or premium to NAV of little value as an indicator for future price movement. Then again, they conclude there is some informational content in the movement of the NAV that suggests something other than pure fundamental analysis setting the share price (August 2005).³ Contrarily, Bleaney, who studied U.K.-specific data, flatly discards any predictive nature to share price from NAV discounts or premiums (2002).⁴

As I see it, the debate continues simply because no one seems to have completely solved the closed end discount puzzle. And, in the absence of any unified explanation, the vacuum is filled with media noise that contributes to generalizations about the persistence of the closed end discount.

You see, though closed end funds can and do trade at a discount to NAV, they also can and do trade at a premium to NAV. But this fact is often overlooked in the financial media. Rarely will investors find an article that recommends buying a closed end at a premium to NAV. Instead, the financial media touts the latest discovery on the cause of the puzzle and then offers a purported trading strategy for successfully navigating the closed end market. Not surprisingly, these strategies seem to rally around a common theme: buy closed end funds at a discount to NAV, sell at a premium--or at least sell at less of a discount to NAV.

I believe this media bias towards discount-based strategies fosters a gross generalization on the part of the uninformed investor that closed end funds normally trade at a discount to NAV. That being said, if the closed end discount puzzle is indeed attributable to a behavioral irrationality rather than a lack of fundamental analysis, well then, as I see it, the discount cannot and will not persist for long. Investors just can’t pass up a sale.

¹ “Investor Sentiment and the Closed-End Fund Puzzle,” by Charles M. C. Lee, Andrei Shleifer, Richard H. Thaler, The Journal of Finance, Vol. 46, No. 1, March 1991, pp. 75-109.

² A Random Walk Down Wall Street, Burton G Malkiel, W.W. Norton & Company, New York, 2003.

³ “The Persistence and Predictability of Closed End Fund Discounts,” by Burton G. Malkiel, Princeton University, and Yexiau Xu, The University of Texas at Dallas, August 2005.

⁴ “Investor Sentiment and Discount on Closed End Funds,” by Michael Bleaney, University of Nottingham, as cited in “Managerial Ability, Compensation, and the Closed End Fund Discount,” by Jonathan Berk and Richard Stanton, University of California Berkley, November 2005.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.