Economics 11/05: Excess Volatility and Closed-End Fund Discounts

Abstract

It is shown that, with fixed transaction costs in the market for risky assets, investors with wealth below a certain threshold will hold pooled index funds that charge a proportional fee, rather than the market portfolio chosen by wealthier investors. If a portfolio of closed-end index funds yields greater volatility of returns to investors than open-end index funds, and charges the same fees, the closed-end funds need to trade at a discount in equilibrium to attract buyers. The same applies to actively managed funds if higher fees fully reflect extra expected returns from the managers’ skill. In this case excess volatility is a sufficient condition for closed-end fund discounts. It is unnecessary for discount risk to be systematic.

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Authors

Michael Bleaney and R. Todd Smith

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