The reaction of closed-end fund share prices to changes in portfolio values is on average the same, whether funds are trading at discounts or premia, and whether the changes in portfolio values are positive or negative. If closed-end fund discounts and premia do correctly measure investor sentiment, then the results suggest that investor sentiment does not affect the market's reaction to news about the fundamentals. Alternatively, discounts and premia may not, in fact, measure investor sentiment, or sentiment may play no role at all in closed-end fund pricing. Noise-trader risk and trading costs also fail to explain the observed behavior.
This paper examines closed-end funds to see whether investor sentiment affects the
market’s reaction to news about fundamentals. Closed-end funds are the perfect
vehicle for this inquiry for three reasons: First, their shares trade on major stock
exchanges exactly like the shares of operating companies (Dimson and Minio-Kozerski,
1999). Second, they publish their portfolio values weekly, meaning that there is very little
uncertainty about the fundamental valuations of closed-end funds or about how those
valuations change over time (Lee, Shleifer and Thaler, 1990). Third, the fact that they
typically trade at discounts or premia to their portfolio values, gives a natural metric for
investor sentiment: Funds trading at discounts are funds about which investors are
pessimistic, while funds trading at premia are funds about which investors are optimistic
(Chopra, Lee, Shleifer and Thaler, 1993).
To examine whether investor sentiment affects the interpretation of news about
fundamentals, I examine how closed-end fund share prices react to changes in fund
portfolio values when conditioning on discount and premium levels. In addition, I look
separately at increases and decreases in portfolio values in order to check whether the
state of sentiment colors the market’s reaction to positive and negative news. I find that
the reaction of closed-end fund share prices to changes in portfolio values is on average,,
the same whether portfolio values increase or decrease, and regardless of the discount or
premium level at which a fund is trading.
This behavior is confirmed by examining a comprehensive data set containing nearly
every US and Canadian closed-end fund trading between 1985 and 2001. Using this data
set, I first sort all changes in portfolio values into positive and negative changes. I do this
because, if sentiment affects the reaction of share prices to changes in portfolio values,
sentimental investors might react differently to good and bad news, i.e., to positive and
negative changes in portfolio values. I then sort the observations in each group by their
associated discount and premium levels. I do this because you might expect optimistic and
pessimistic investors to react very differently to changes in portfolio values. |
