Academic journal article Quarterly Journal of Finance and Accounting

Price Stabilization of Closed-End Fund IPOs

Academic journal article Quarterly Journal of Finance and Accounting

Price Stabilization of Closed-End Fund IPOs

Article excerpt

Introduction

Between 2002 and 2006 investors in the United States invested over $100 billion into 245 closed-end funds (CEFs) through initial public offerings (IPOs). The purchase of a CEF at the time of the IPO is puzzling because, on average, Weiss (1989) finds that CEFs trade at a significant discount to the offering price only 40 to 60 trading days after the offering. Much of this decline is due to underwriting fees that are embedded in the offer price. CEF shares, therefore, are sold at an implicit load at the time of the IPO, and the aftermarket price should be equal to the offer price minus the underwriting fee. Because investors purchase CEF offerings without paying an explicit sales commission to the selling broker, they may be led to believe they are paying no fees at all.

Hanley, Lee, and Seguin (HLS) (1996) use a sample of mostly bond funds to argue that underwriters attempt to prolong this no-load illusion by hiding their charges from investors through price support. Leonard, Nixon, and Shull (LNS) (2005) use a sample of international equity CEFs, however, and find no evidence that underwriters excessively prolong the price support period. The purpose of this paper is to use the largest and most diverse sample that has been studied to date to determine whether underwriters prolong the price support period for CEF IPOs. Our sample includes 245 CEFs (114 bond CEFs, 115 US equity CEFs, and 16 international equity CEFs) and uses the post-decimalization period of 2002-2006.

Hanley, Lee, and Seguin (1996) provide evidence supporting a marketing hypothesis first presented by Weiss (1989) and Peavy (1990). The marketing hypothesis argues that savvy investment professionals sell CEFs to less-informed individual investors. HLS use an algorithm developed by Lee and Ready (1991) to show that underwriters attempt to support fund prices even though there is an imbalance of selling pressure immediately following the offering so that investors may not understand the true cause of the price decline. Because of price support, the fund does not lose value during the first three weeks after the offering; investors may be likely to attribute the eventual decline and the fact that the fund is trading at a discount to NAV to market conditions, rather than to underwriting charges. [1]

Leonard, Nixon, and Shull (2005) use a sample of 89 international equity CEF IPOs and find no evidence that underwriters extend the price support period. We argue that the main reason their results differ from those of HLS is that the two studies use different samples. HLS use a sample of 59 bond funds and six international stock funds. The only overlap between the HLS sample and the LNS sample is the six international stock funds. LNS observe that because of the underlying investments in their portfolios, bond funds are inherently stable and have much less volatility than international equity funds. Therefore, the HLS finding of no median price change for the first 29 trading days could be due to the low price volatility of bond funds, which makes it difficult to disentangle the effects of price stability and price support.

The purpose of this paper is to use a larger, more inclusive sample to answer the question of whether underwriters excessively support CEF IPO prices and to examine whether there is additional evidence to support the marketing hypothesis.

In order to answer these questions, we propose a new method to determine when a fund's price is being supported and when this support ends. Specifically, we define the end of the price support period to be the first day that the fund trades more than $0.25 away from the IPO price. [2] We report bid-ask spread data and fund return data that show funds are different prior to and after breaking through the $0.25 boundary. We examine funds from the post-decimalization period because this method enables us to avoid the potential problems associated with a sample containing minimum price increments and bid-ask quotes of an eighth ($0. …

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