Two common phenomena in the mutual fund industry have long puzzled scholars of finance. The first is the overwhelming predominance of open-end funds, which allow shareholders to buy shares or redeem their shares at any time, in comparison to closed-end funds, whose rules prohibit share redemption, forcing shareholders to use a secondary market if they wish to sell their shares. The total net asset value of open-ended funds in the United States was $11.6 trillion at the end of 2011, compared to just $239 billion invested in closed-end funds. The second puzzle is the fact that closed-end funds commonly trade at a discount, meaning they are bought and sold in these secondary markets at a price below the market value of the assets they hold.
From a theoretical point of view, closed-end funds have many attractive features. With a more stable asset base, managers are better able to implement and execute investment strategies, which should benefit the investors. Also, open-end funds can grow larger as more people invest, and this makes it more difficult to generate superior performance going forward, but a closed-end fund doesn’t have this problem, since its asset base is relatively constant (it can only be expanded through internal growth or a seasoned equity offering).
Working with Russ Wermers
of the University of Maryland and Josef Zechner
of Vienna University of Economics and Business Administration, I examined manager compensation and discipline in a sample of 1,183 fund managers. Other researchers have conducted analyses at the level of the individual fund, but this approach fails to account for the fact that talented managers are often rewarded by being given additional funds to manage. Therefore, our working paper
takes the innovative approach of conducting analysis at the level of the individual manager.
Our findings suggest explanations for why closed-end funds fail to attract more investors and assets. We find that closed-end fund managers have more market power than the funds’ investors. When closed-end funds trade at a premium, their managers are able to capture rents in the form of increased compensation or expansion of the assets they manage, but when funds trade at a discount, their managers are not penalized accordingly, and fund governance is not effective at disciplining unskilled managers. Asset expansion benefits managers since it brings higher income from fees, but it hurts investors since fund performance and premium decline as fund size grows. Consistent with weak governance and manager entrenchment, we also find that fund performance and premium decrease as manager tenure increases. Furthermore, for funds whose managers have long tenure, poor performance and discount are more persistent than good performance and premium.
Effective governance of mutual funds is supposed to prevent unskilled managers from destroying shareholder value. Currently, the same set of rules applies to both open-end and closed-end funds. Yet, open-end funds contain an inherent mechanism for discipline, as investors can withdraw capital at any time; investors in closed-end funds cannot redeem their shares when they are dissatisfied. We believe that revising regulations to strengthen governance mechanisms and better protect shareholders would make closed-end funds a more attractive investment option.