Termination of closed end funds and behavior of their discounts

Based on an extensive sample of U.S. closed-end funds undergoing open-ending, we examine the behavior of discounts prior to the announcement till open-ending. Discounts are significantly reduced upon announcement of open-ending with price increase. Announcement period return is directly related to the pre-announcement discount, and other hypothesized characteristics of the fund and investor behavior. The role of investor sentiments as an explanator of discounts is weaker after announcement. We decompose the pre-announcement discount into structural and idiosyncratic parts, and report that there is a greater reduction of the idiosyncratcic part of the discount at announcement. Time series behavior of discounts lends support to investor confidence. We find that small amounts of discounts remain at the time of the open-ending.Closed-end funds, open-ending, discounts, investor sentiment.

The behavior of discounts of closed-end funds undergoing open-ending

Based on an extensive sample of U.S. closed-end funds undergoing open-ending conversion, we examine the behavior of discounts prior to the announcement till the date of open-ending. Discounts are significantly reduced upon announcement of open-ending with price increase. Announcement period return is directly related to the pre-announcement discount, liquidity, and other characteristics of the fund. We decompose the pre-announcement discount into structural and diosyncratic parts, and report that there is a greater reduction of the idiosyncratcic part of the discount. We examine the role of distributions to the investors on the size and behavior of discounts subsequent to the open-ending announcement. We find that small amounts of discounts remain at the time of the open-ending and investigate potential explanations for such discounts.closed-end funds, discount

Investor Sentiment and Fund Market Anomalies: Evidence from Closed-end Fund, Exchange-traded Fund and Real Estate Investment Trust

The investor sentiment hypothesis has become a promising avenue by way of a behavioural approach to complementing conventional explanations of financial market anomalies. In response to the problems exhibited in the existing theories, the investor sentiment hypothesis has been widely tested and the results of which turn out to be able to successfully explain the market anomalies to a great extent. The thesis applies the investor sentiment theory to analysing the fund anomalies in both the UK and US markets. The test results and their interpretations may help promote a better understanding of the investor sentiment and its impacts including their geographical differences. We contribute to the literature by focusing on the sentiment measures, among others. Since the investor sentiment reflects the investors’ behaviour and psychology, it is hard to be properly captured. We have constructed the proxies for the sentiment factor in both direct and indirect forms. The first fund anomaly we analysed is the “closed-end fund puzzle”. The puzzle is so-called because at IPO, the fund is issued at a premium to the net asset value (NAV); however, thispremium disappears in the next few months. The fund then trades at a discount. This discount is not fixed, varying substantially during the closure period. When the closed-end fund is either converted into an open-end fund or liquidated, the discount shrinks and the share price will rise. We construct an out-of-sample test by using the two-factor and five-factor models. The results show that the investor sentiment can contribute to explaining closed-end fund discounts in the UK market and it is more prevalent in smaller size portfolios. We also find the evidence to support investor sentiment as an important factor to represent systematic risk in the return generating process. Next, we examine the price deviations of Exchange Traded Funds (ETFs). Unlike closed end funds whose prices also deviate from the NAV, ETFs, through a mechanism known as redemption in-kind, allow institutional investors to potentially earn a profit by arbitraging away these price deviations through creating and deleting outstanding shares of the ETF. Hence, we are motivated to identify the factors that may impact on the determination of these premiums and discounts to the NAV. We first construct a sentiment proxy from the derivative market variables such as the option put–call trading volume ratio and the open interest ratio. Then we develop a sentiment proxy based on the consumer confidence index, obtained from the mainstream consumer surveys and this proxy is taken to the individual fund level. The results provide evidence that this sentiment proxy has explanatory power for most individual ETF mispricing. We take the whole industry into account and find that the sentiment factor has incremental explanatory power and is positively related to the fund premium. The evidence also shows that more sentiment-sensitive ETFs are those that have smaller, younger and volatile stocks with low dividend yields. Finally, the thesis considers the fund anomaly in the form of the REIT price momentum. In order to investigate the momentum profitability, we classify the formation period into two sentiment states, i.e. the optimistic and pessimistic periods. Evidence indicates that when sentiment is high, the REIT momentum profitability is substantial and significant; however, when the sentiment is low, the profits from the REIT momentum are much lower and not significant. We also examine the interplay between REIT liquidity and momentum profitability. We find that high REIT liquidity portfolios generate higher momentum returns, but this is only significant when the sentiment is optimistic. Furthermore, consistent with our previous findings, our evidence that momentum is generally larger for smaller companies confirms that the size effect is still available in the REIT industry. This is because the smaller companies are often difficult to value, as they are more prone to subjective evaluations. The sentiment thus could be more significant in small size companies

A multivariate analysis of rational and behavioral factors that may explain the existence of discounts (premiums) of closed-end investment funds

Using multivariate analysis and based on a theoretical framework that we call hybrid theory (which considers rational and behavioral explanations for the close-end investment funds discounts/premiums), we intend to test the validity of certain factors such as agency costs, dividend policy and liquidity (so-called rational factors), combined with investor sentiment and limits to arbitrage (behavioral factors) to explain the structure of closed-end funds discounts (premiums) in the US market. Note that, as far as we know, few empirical papers have tested the validity of this approach. Based on a sample of 346 US closed-end funds, we present evidence that dividend policy (dividend yield), the portfolio composition (restricted assets) and turnover ratio, as well as the investor sentiment and replication costs (as arbitrage limits) are statistically significant variables by the multivariate regression analysis undertaken, which seems to support empirically the hybrid hypothesis. This paper also intends, by stepwise discriminant analysis, to identify which of these explanatory factors of closed-end funds discounts (premiums) contribute most to discriminate between bond and equity funds. Results indicate that the dividend yield, management fee and replication costs (limits to arbitrage) are the main contributors to the discriminant function, with about 92% of the funds properly classified

The trading volume trend, investor sentiment, and stock returns

This dissertation relates the information contained in past trading volume to investor sentiment, and investigates its ability in predicting stock returns. Investor sentiment here refers to the enthusiasm of irrational investors on an asset, relative to that of rational investors. Motivated by Baker and Stein (2004) that an increase in trading volume reflects a rise in investor sentiment, I use the change in trading volume per unit of time, referring it as the trading volume trend, as a measure of investor sentiment on individual stocks. I document a negative and significant cross-sectional relation between the trading volume trend and stock returns, both in the short term and in the long run. This relation is dynamic and holds after controlling for several liquidity measures and other possible determinants of expected returns. It also holds for various volume measures and momentum portfolios. Specifically, both winner and loser portfolios show the effect of the trading volume trend. The effect exists in stocks of small and large firms, and in optioned and non-optioned stocks. These findings suggest that the negative effect of the trading volume trend on stocks returns is robust. Moreover, a composite trading volume trend, formed on the trading volume trends of individual stocks, can predict both the equally-weighted and the value-weighted market returns in the expected direction, after controlling for other possible determinants of market returns. The composite trading volume trend also explains closed-end fund discounts. Collectively these findings support that the trading volume trend contains information on investor sentiment, and that investor sentiment has a valuation effect on stocks

Effects of Regulatory and Market Constraints on the Capital Structure and Share Value of REITs: Evidence from the Italian Market

In contrast to the US experience, most international (European) real estate investments trusts (REITs) are subject to prudential regulation. This paper investigates the effects of prudential regulation on capital structures and consequently, the REIT share values of major legal and market constraints (i.e. leverage limitations, market discount on net asset value (NAV), tax controls) that affect non-US REITs. Italian market data are used for an empirical analysis. Our hypothesis is that in a constrained environment, the effects on share price significantly depend on the adopted valuation perspective, i.e. if shares are valued by following a NAV or a financial approach. The logic for this hypothesis is that the two valuation methodologies perceive leverage and implied financial risk differently. In particular, we argue that NAV valuation techniques incentivise REITs to maximize leverage regardless of the financial theory which indicates a contrasting impact of debt on the market value of shares. Differences in financial risk perception could also partially explain market price discounts on NAVs.The empirical results seem to support these expectations. Almost all Italian REITs tend to increase debt ratios over time. NAV discounts are significantly related to leverage. The discount effect is largely attributable to NAV increases that result from rising debt levels. On the contrary, share market prices tend to be independent from leverage. The latter result may indicate that the classic capital theory applies and current debt ratios do not imply bankruptcy risk. The results have significant policy implications in terms of an optimal regulatory design.REIT regulation; Leverage; NAV discount; REIT capital structure; REIT valuation

ESSAYS ON FORCES UNDERLYING 2008 FINANCIAL CRISIS: CREDIT RATING AGENCIES AND INVESTOR SENTIMENT

The roots of the 2008 financial crisis are often traced back to the collapse of the housing bubble. The factors that precipitated the crisis, and propagated its effects on firms and consumers to produce an economic contraction, are still the subject of ongoing debate among academics, policy makers, and practitioners. Macroeconomic factors, flawed government policies, and perverse incentives at financial institutions that lead to excessive risk taking are often cited as contributing forces to the crisis. In this dissertation, I investigate two forces that drove the 2008 financial crisis. One force is the credit rating agencies, whose excessively generous ratings lie at the root of the 2008 financial crisis. The popular claim is that the rating agencies have become too loose at their rating assignments, which led to overestimation of the creditworthiness of the companies by the public. In this dissertation, I examine the assertion that the rating companies have progressively relaxed their standards in recent decades for corporate credit ratings. Such relaxation seems to have lulled investors into a false sense of security about the safety of credit instruments whose values collapsed abruptly. Next I examine the contagion effects of rating downgrades. I ask whether rating downgrade news have spill over effects on the rest of the industry. I then investigate a different force that has received less attention in the crisis; investor confidence. The third essay focuses explicitly on the period when the financial crisis was at its peak. In Essay 1 titled, "Structural Shifts in Credit Rating Standards", I examine the time series variation in corporate credit rating standards for the period 1985-2007. I report two main findings: (i) There is a divergent pattern between investment grade and speculative grade rating standards during 1985-2002. Investment grade ratings tighten between 1985 and 2002. In contrast, the speculative grade rating standards loosen during the same period. Consistent with an agency explanation, rating companies assign more issuer friendly ratings to speculative grade credits, where there is substantial growth by the first-time entrants. The loose standards in speculative grade ratings are consistent with widespread criticism of the rating agencies during the Dot-Com crash. However, while the media focused on failure of rating agencies in high profile corporate debacles, the more serious problem was in the speculative grade rating assignments. (ii) There is a sharp structural break in both investment grade and speculative grade standards towards more stringent ratings around 2002. The change in rating levels due to the structural break is both economically and statistically significant. Holding firm characteristics constant, firms experience a drop of 1.5 notches in ratings due to tightening standards between 2002 and 2007. It appears that widespread criticism and threat of regulation led rating agencies to move towards more conservative ratings after the Dot-Com crash, Enron debacle and passage of Sarbanes-Oxley Act. In Essay 2 titled "Contagion Effects of Rating Downgrade Announcements", we examine the intra-industry spill over effects of rating downgrade announcements based on abnormal returns for stock and CDS spreads of competitor industry portfolios. We find minor contagion effects for the equity prices of the industry portfolios for the entire sample. For the competitors of investment grade firms, we find significant contagion effects in the magnitude of -15 basis points for the window (0,1). For the speculative grade sample, we do not observe contagion or competition effects although this result can be due to cancellation of contagion and competition effects for the low rated firms. These results suggest that the net effect is dependent on the event firm's original rating. We find statistically significant CDS reaction of industry portfolios to downgrade news although in moderate magnitudes. The cross sectional tests show that the industry portfolio equity response and event firm equity response are positively correlated. This finding presents further evidence of contagion effects for rating downgrades. Essay 3 discusses a different force that has received less attention in the financial crisis, investor sentiment, and focuses on data drawn from the crisis period. In Essay 3, titled "Confidence and the 2008 Financial Crisis", we examine the role of confidence in the 2007-2008 financial crisis using new high frequency data on daily closed-end fund discounts and novel measures of consumer sentiment from non-financial sources extracted at daily frequency. Empirically, there is some movement in sentiment through much of the crisis period but it is relatively moderate. However, tests detect a sharp structural break around the Lehman bankruptcy, after which there are breaks in both pricing across multiple asset classes and co-movement, especially in hard-to-arbitrage fund classes. Fund discounts also exhibit significantly increased co-movement with non-financial Gallup sentiment measures after the Lehman bankruptcy, and closed-end fund discount betas with respect to the market increase significantly during this period. While fund discounts may reflect liquidity issues in normal conditions, they seem to better reflect sentiment in stressed environments, so funds have undesirable conditional betas. The results are consistent with the view that the Lehman bankruptcy induced a negative shock to the supply of arbitrage capital, and as predicted by behavioral finance models of costly arbitrage, sentiment then matters more and is closely tied to returns. The results are also consistent with theories of financial crisis in which sentiment or confidence is an extra force that amplifies and transmits economic shocks that add to the usual credit and collateral mechanisms studied in the literature

Discounts in Closed-End Funds - A Study on the Swedish Market

The thesis strives to use previous research as a basis to perform an up-to-date and relevant study about the CEF puzzle on the Stockholm stock exchange. Annual data for the whole population of Swedish CEFs will be studied over the time period 2006-2010. A multiple regression analysis will be executed in order to determine the impact of a number of explanatory variables on the CEF discounts. The regression performed did show significant impact on the CEF discounts for a number of explanatory variables: dividends, ownership concentration, fund age, and fund diversification. The results can be explained by financial theory in conjunction with the features of the Swedish CEF market. The Swedish population of CEFs is limited, why it could be of interest to incorporate other Nordic markets in future research