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The Price is Right. Or is It?
By Artashes Toumanov, TheWorldJournal.com

Ever bought a stock? If ‘yes’, then this will be a good reminder of what really rules the market. If the answer is ‘no’, then bear with me, and you will fathom why most people find this addictive game full of surprises.

Now, before going any further, please remember that there are no such things as free lunches or easy ways to make money. In other words, no riskless money-making opportunities exist. This little reminder will help you go through some of our research questions and analysis.

In this article I’m going to talk about Closed-End Mutual Funds, or for simplicity of the term – just a fund, stock, bond, - whatever makes you comfortable. Closed-end mutual funds were chosen for a number of reasons: the issued number of them is fixed; their price is set by supply and demand (which give birth to a market price – thus it can be different from their net asset values) and, most importantly, their real value is relatively easy to estimate. The last factor makes it easy to separate when the fund is being sold at a discount (for less that its net asset value) or at a premium (for more than its net asset value).

Even though closed-end mutual funds’ natural value is easy to measure, which makes market price based on the net asset value logical, when it comes to buying and selling, it is noted that the price is often over-, or undervalued. Based on profound research made by economists, four major anomalies help us get a picture of fund’s pricing behavior. Later in the article a few theories will be provided in order to understand the operation of financial markets as well as to see if there is any correlation between anomalies and economic theory.

Major Questions

Coming on the market, new funds tend to grow in value in the very beginning, thus being sold at a premia (more than its market value). However, after 15-20 weeks the fund drops in value to an average of 10% below of its original value, consequently being sold at a discount. The question being asked is why traders buy these overvalued funds in the very beginning if the average return over the period is negative (approximately -25%)?

The second question arises from fund’s real pricing behavior. Watching the prices of closed-end funds, its being noted that over a long period of time they are being sold at a little discount of approximately 10%. Even though some funds’ pricing is overvalued, discounts are the norm for a market, which begs for a simply question – why is it a norm?

It is also known for a fact that even the largest funds traded experience periodical change in price. From time to time they are being sold for a premium, then later with a big discount. It’s extremely important to notice that seasonal patters are unexplainably influencing prices of the funds as well, even though economists report this to be wrong. Not only it brings a question of why won’t prices stay at the market price level, but why would they vary so much?

It is understandable that when funds are liquidated or converted, the price should be equal to net asset value in order to let liquidation pass correctly. As a result, the price will fall if it was higher. But as some theories tell us, if the net asset value was reported with a mistake, then it is more likely than net asset value will fall to the market price in case it is terminated, than rise. The question is why would prices rise in some cases to close the discount gap?

Proposed Explanations

Researchers’ approach to studying how prices can differ from basic financial values resulted in several major explanations.

The first proposed explanation is based on the fact that a presence of administration over these funds can influence prices. Well, if there is management, then there might be a usual management fee, which could certainly explain why funds should be selling on average at a discount. However, buying fund’s assets at a discount rate are far more profitable for investors, so that management fee should not be considered that important for them. Ergo, the presence of fees does not explain why funds are selling at a discount.

The second aspect of having a management is based on its activities. Buying and selling is considered to be a continuous action for managers, thus portfolio value may vary. But as present portfolio value, which changes throughout time, is used to determine the expected returns, the prediction might be wrong, resulting in funds selling at a discount. At the same time, large discounts are supposed to predict poor future performance and premia suggests positive future returns. This is not true in reality, as some researches actually proved funds with bigger discounts outperform those with smaller ones. Consequently, the miscalculation of net asset value cannot explain the pricing behavior of closed-end mutual funds.

One more way to misvalue the portfolio is if the fund holds a large number of restricted stocks, which could not be sold fast enough in case of financial failure, liquidation or merger. This kind of stocks are said to be valued too high when calculating net asset value. However, as funds usually keep a small number of restricted stocks, they make little or no implication of why stocks are sold at a discount.

One of the most favorite excuses can be summarized in one word – taxes. When a fund makes money, it should pay taxes – easy as that. So taking into account that shareholders should pay taxes when capital gain is realized makes it logical to assume that funds with huge unrealized capital gain would worth less to investors. As a result, these funds will be undervalued and they will be sold at a discount. However, in 1977 one researcher calculated that taxes cannot cause a discount of larger than 6%, so if a fund is being sold at a greater discount, there is no way to find the real cause of that.

Investors’ Rationality

We already heard the story about investors buying overvalued newcomer funds, which then tend to have a negative return throughout the next 15-20 weeks. This and other facts make us seriously consider investor’s rationality in all this and see if it has any connection with fund’s pricing behavior.

Surprisingly, we find that psychological state of investors plays an important role on the market, so stop looking funny at people who say, “fear rules the market”. Apparently, it does.

Take, for example, the stock market crashes: either the Great Crash of 1929, or the one we had a couple of years ago. Both financial catastrophes had similar characteristics: corporate earnings were growing unproportionally faster than the economy itself, stocks were highly overvalued (thus selling at a huge premium) and investors were highly optimistic and refused even to consider the possibilities of a discount on the closed-end funds. Some economists call that “investor’s stupidity”, others say that they have to be especially careful, as the price is overvalued when arbitrage should keep them equal to values.

When it happens, it is easy to see the possibility of investor’s arbitrage: buy low, sell high. But it was of course takes into account and the trouble of arbitrage is being solved by several measures to prevent this. For example, the process of short selling was retransformed into a more complex transaction: it does not happen immediately, raising the cost of this trade; or the premium could get even larger, resulting in capital loss. Funds also have means to defend themselves in case some individuals with really big pockets decide to take over the fund and liquidate it for example, or if their bid is for a full net asset value. However, when we look at it from above, it seems that these deals are not that attractive as there are always a lot of stocks with quite big discounts available.

Concluding our conversation about investors’ rationality, I would like to mention the result of one more research made by Delong, Shleifer, Summers and Waldmann in 1990, which clearly reveals “fear” as a term. They created a model with two kinds of traders: rational (who are risk-averse) and noise (irrational). Noise traders do everything rational traders don’t: they make wrong predictions and make irrational decisions. Absolutely amazing results reveal the following: rational traders, being risk-averse, were influenced by the psychological state of noise traders and the market. In times when noise traders were highly enthusiastic and optimistic about the market, rational traders followed the mood and were ready to buy overvalued assets (at a premia); at times when noise investors were pessimistic, rational traders hesitated to buy closed-end funds even at a big discount expecting more poor or negative returns.

Analysis Conclusion

The major lesson we’ve learned from our analysis about the closed-end mutual funds is that market’s psychological state has its influence on fund’s price and no matter how irrational beliefs an investor might have, the demand for this type of securities can influence price as well. And there will always be someone who is ready to buy and sell funds and either discounted or premium price because, as we started the article, we’ve proved that no riskless arbitrage opportunity exists.

Based on the article by Charles M. C. Lee, Andrei Shleifer, and Richard H. Thaler,
“Anomalies: Closed-End Mutual Funds”.
Journal of Economic Perspectives - Volume 4, Number 4 - Fall 1990 - Pages 153-164

© April 10, 2002