A Positive Theory of Closed-End Funds as an Investment Vehicle

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Abstract
The paper offers a positive theory of the closed-end fund as an efficiency-driven organizational form of fund management. The theory is based on the observation that a closed-end fund is a public company with a guaranteed, long-term annual compensation for Fund management and on an assumption (acceptable within the classical rational-and-efficient-markets paradigm) that some small investors may place a lower premium on an asset's liquidity than the Market, yet are unable to acquire the asset directly. A closed-end fund serves this clientele; the value of the closed end fund's shares is an algebraic sum of the assets-under-management plus the [capitalized] value-added by clientele service minus the [capitalized] value of the costs-of-management. This approach is rich enough to explain the persistence of discounts, the relationship between a Fund's discount and its dividend policy, the zero correlation between discounts and interest rates, and the excess volatility of a Fund's share price. The paper's arguments are supported by our preliminary empirical study.