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RFS Advance Access published online on April 2, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn028
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© The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

A Liquidity-Based Theory of Closed-End Funds

Martin Cherkes
Columbia University

Jacob Sagi
Vanderbilt University

Richard Stanton
University of California, Berkeley

Send correspondence to: Richard Stanton, Haas School of Business, 545 Student Services Building #1900, University of California, Berkeley, CA 94720-1900; email: stanton{at}haas.berkeley.edu.

JEL Classification: G14


  Abstract

This paper develops a rational, liquidity-based model of closed-end funds (CEFs) that provides an economic motivation for the existence of this organizational form: They offer a means for investors to buy illiquid securities, without facing the potential costs associated with direct trading and without the externalities imposed by an open-end fund structure. Our theory predicts the patterns observed in CEF initial public offerings (IPOs) and the observed behavior of the CEF discount, which results from a trade-off between the liquidity benefits of investing in the CEF and the fees charged by the fund's managers. In particular, the model explains why IPOs occur in waves in certain sectors at a time, why funds are issued at a premium to net asset value (NAV), and why they later usually trade at a discount. We also conduct an empirical investigation, which, overall, provides more support for a liquidity-based model than for an alternative sentiment-based explanation.

For helpful comments and suggestions, we thank an anonymous referee, Yakov Amihud, Michael Brennan, Joe Chen, Chris Downing, Darrell Duffie, Wayne Ferson, Mike Fishman, Itay Goldstein, Martin Gruber, Joel Hasbrouck, Robert McDonald (the editor), Jeff Pontiff, Mark Rubinstein, Ronnie Sadka, Clemens Sialm, Matthew Spiegel, Phil Strahan, Marti Subrahmanyam, Russ Wermers, Chunchi Wu, Youchang Wu, Josef Zechner, and seminar participants at UT Austin, Boston College, Carnegie Mellon, Hebrew U., HKUST, Northwestern, NYU, Tel Aviv U., Texas A&M, U. Alberta, U.C. Berkeley, U. Calgary, U. Colorado, U. Michigan, UNC, U. Utah, Vanderbilt, Wharton, the 2005 Financial Research Association meeting, the 2006 Utah Winter Finance Conference, and the 2006 Caesarea Center conference. Financial support from the Fisher Center for Real Estate and Urban Economics is gratefully acknowledged.


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