Market Efficiency and the Close-End Fund Puzzle
The ability of market prices to reflect all available, relevant information, is a core element of conventional financial theory (Fama, 1970). The main insight is that the market does a fairly good job in disseminating available information. This allows, in its turn, investors to estimate the ‘fundamental’ ability of a financial security to generate future cash flows, in relation to the underlying risk, and bring market prices close to their ‘intrinsic value’. Notwithstanding an initial appearance as an exceptionally solid proposition both from a theoretical and empirical point of view, market efficiency has gradually been challenged (see for example Shleifer, 2000; Malkiel, 2003; Lim and Brooks, 2011).
The problem with the debates on market efficiency is that the underlying ‘fundamentals’ of the valuation process are not directly observable. The results of any empirical research cannot safely distinguish between the validity of the assumed valuation theory and the validity of market efficiency per se. Every test of market efficiency must rely on an assumed valuation model. However, closed-end funds (CEFs) offer a rare case in which fundamentals are directly observable. The valuation of CEFs has thus been a core theme in the debates about market efficiency because these funds provide an ideal vehicle for studying mispricing in financial markets.
CEFs or investment trusts issue shares and fixed-interest securities, which are traded in secondary markets. They use the funds raised by such issuance to create an investment portfolio. These funds are thus closed-end funds in the sense that their capitalization is fixed (unless there are new issues of securities), and the supply of shares is inelastic. Shareholders can exit a CEF at any time by selling their shares in a secondary market. The fund has no obligation to redeem investors’ holdings. Market efficiency would presume that the price of a CEF’s issued share should be the same as the per-share market value (net of any liability) of the assets within the fund’s portfolio, or the so-called net asset value (NAV) of the CEF.
There has been a voluminous amount of research observing that from the 1970s this was not the case (see Cherkes, 2012 for a survey). A CEF trades at a discount (premium) to the NAV when its market capitalisation is lower (higher) than the underlying portfolio’s NAV. If a CEF trades at a discount or premium to NAV, the ordinary share price deviates from its ‘fundamental value’. And since this fundamental value is the observable NAV, the question becomes why the market can sustain such a difference. This deviation violates one of the most basic principles of neoclassical finance, the law of one price (or the no-arbitrage principle), according to which equivalent assets should converge to an identical price. This pricing mismatch has been labelled the ‘closed-end fund puzzle’, an anomaly that challenges the main assumption of the traditional finance paradigm.
The Case of UK Investment Trusts Before WWII
Our analysis approaches the debates on market efficiency and the valuation of CEFs from a historical angle. It is focused on UK investment trusts before WWII. Up to the 1930s, UK financial markets were a global financial hub, with the London Stock Exchange (LSE) being the world’s largest, most sophisticated, and most organized market. In the wake of the introduction of limited liability laws for companies in the 1850s and 1860s, the UK investment trust sector was established to offer asset management services to individual investors. This type of CEF was the first investing institution to fully adopt the strategy of international portfolio diversification.
While there is extensive literature on modern examples of the CEF pricing puzzle, there have been only a handful of studies using data from before the 1960s that address the same question. Our study (Sotiropoulos, Rutterford and Tori, 2022) is the first to investigate the CEF pricing puzzle of the UK investment trust sector for the 50 years between 1880 and 1929. Our dataset comprises hand-collected data from the CEFs’ annual reports archive held in the Guildhall Library in London as well as market price data from the Stock Exchange Yearbook (SEYB).
The results of our study reveal the long-term trend of the CEF pricing puzzle. Our calculations show significant variation between share prices and underlying NAVs, both across investment trusts and throughout the period of our analysis. We find a tendency for trusts to trade at a discount to NAV, but this tendency was reversed in the 1920s. The median discount was 5.5 per cent for the fifty years before 1930, but it became a 2.4 per cent premium in the 1920s. This gradual shift over time towards a premium was accompanied by a very high cross-sectional variation: a finding that indicates significant evidence of the pricing puzzle.
The Puzzle’s Long History and Investor Behavior
Our study also discusses the reasons for the CEFs pricing mismatch and assesses what that implies for UK investor behaviour. Although there has been important research on the history of investor behaviour and market imperfections (see for example Barsky and De Long, 1990; Campbell et al., 2018; Sotiropoulos and Rutterford, 2018), approaching the same questions from the viewpoint of the CEF pricing puzzle offers a fresh new angle.
We provide both textual and econometric evidence that UK investors had some understanding of the relationship between CEF share price and the underlying fundamental NAV. In this sense, investors before WWII behaved rationally (and markets efficiently) with a tendency to correct high pricing deviations/mismatches. However, this correction was not substantial enough to avoid significant mispricing. Investors were also keen to reward performance, as captured by realized returns and nominal dividend yields. Higher realized income and capital gains were associated with lower discounts or higher premia to NAV for the investment trusts in our sample. To the extent that this performance could be linked to asset managers’ skills, our results suggest that investors would be willing to pay more (less) than the NAV in the anticipation of higher (lower) future profits. But again, the residual mispricing remained high. We also find some evidence that part of the pricing mismatch can be explained by the sentiment of individual investors. It seems that UK investors related performance to fundamental values but may also have been driven by waves of pessimistic or optimistic sentiments.
As expected, our study has not been able to settle the market efficiency debate. But it adds an interesting new angle addressing the historical perspective. Our findings show that the closed-end fund puzzle was alive and kicking well before WWII. The puzzle seems to have a longer history than mainstream finance had thought.
About the Authors:
Dimitris P. Sotiropoulos is Senior Lecturer in Finance at the Open University Business School, UK. Email: dimitris.sotiropoulos@open.ac.uk
Janette Rutterford is Professor of Financial Management at the Open University Business School, UK. Email: j.rutterford@open.ac.uk
Daniele Tori is Lecturer in Finance, the Open University Business School, UK. Email: daniele.tori@open.ac.uk
References
Barsky, R.B., De Long, J. B. (1990). ‘Bull and bear markets in the twentieth century.’ The Journal of Economic History, 50(2):265-281.
Campbell, G., Quinn, W., Turner, J., Ye, Q. (2018) ‘What Moved Share Prices in the Nineteenth-Century London Stock Market?’ Economic History Review 71(1):157–89
Cherkes, M. (2012) ‘Closed-end funds: A survey.’ Annual Review of Financial Economics 4 (2012): 431-445.
Fama, E. (1970) ‘Efficient capital markets: A review of theory and empirical work’. Journal of Finance, 25:383–417.
Lim, K.P., Brooks, R. (2011) ‘The evolution of stock market efficiency over time: A survey of the empirical literature.’ Journal of economic surveys, 25(1):69-108.
Malkiel, B. G. (2003). ‘The Efficient Market Hypothesis and Its Critics.’ Journal of Economic Perspectives, 17(1):59-82.
Shleifer, A. (2000) ‘Inefficient Markets: An Introduction to Behavioral Finance’ (Oxford, 2000; online edition, Oxford Academic, 1 Nov. 2003), https://doi.org/10.1093/0198292279.003.0003, accessed 28 Nov. 2022.
Sotiropoulos, D.P., Rutterford, J. (2018). ‘Individual investors and portfolio diversification in late Victorian Britain: how diversified were Victorian financial portfolios?’ The Journal of Economic History, 78(2):435-471.
Sotiropoulos, D., Rutterford, J., Tori, D. (2022). ‘U.K. Investment Trust Valuation and Investor Behavior, 1880–1929.’ The Journal of Economic History, 1-39. https://doi:10.1017/S0022050722000365
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