The purpose of the present paper is to evaluate empirically an explanation of the closed-end fund puzzle based on the idea that rational investors interact in financial markets with noise traders who are less than fully rational. Investor sentiment - defined as the component of expectations about asset returns not warranted by fundamentals - can lead to fluctuations in demand for closed-end funds and, consequently, to changes in prices.
The authors review in Section 2 the existing explanations of the closed-end puzzle and conclude that they cannot, either singly or collectively, explain the puzzle. In Section 3 they review the concept of "investor sentiment" as introduced by De Long, Shleifer, Summers and Waldmann and make the additional crucial assumption that noise traders are more likely to hold and trade closed-end funds than the underlying assets in the fund's portfolios; arguments are also given why arbitrage opportunities are not left open to rational investors.
In Section 3 the data and the variables used are presented and in Section 4 the empirical implications of the theory are tested: the hypothesis that individual investor sentiment is important for the prices of closed-end mutual funds is found consistent with the data. In Section 6 the robustness of the results is tested and in Section 7, the authors examine the relationship between the discount on closed-end funds with measures of risk and with other indices of investor sentiment.
The basic conclusion of the paper is that closed-end funds discounts are a measure of the sentiment of individual investors which generates a non-fundamental risk within the system. Average discounts exist because the unpredictability of investor sentiment impounds an additional risk to holding a closed-end fund: discounts are high when investors are pessimistic about future returns, and low when investors are optimistic.
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