Academic journal article Financial Services Review

Closed-End Investment Companies: Historic Returns and Investment Strategies

Academic journal article Financial Services Review

Closed-End Investment Companies: Historic Returns and Investment Strategies

Article excerpt

Studies conducted in the past have identified inefficiencies in the market for ClosedEnd Investment Company (CEIC) shares. In addition, studies have demonstrated the potential for trading strategies to exploit these inefficiencies. The purpose of this paper is to investigate the possibility of achieving excess returns through the utilization of relatively simple strategies not requiring continuous monitoring of discount(s) or frequent trading. Our investigation demonstrates that realizing excess returns through the use of simple mechanical trading strategies will not be possible.

I. INTRODUCTION The purpose of this study is to test for Closed-End Investment Company (CEIC) market inefficiency, and therefore the possibility of excess profits. Prior studies have developed complex trading strategies that outperformed the market. Our concern is whether small investors can expect to exceed market returns using uncomplicated techniques to select funds. The plan to be tested is much like the "Dow Dogs" strategy of buying the five Dow Jones Industrial stocks that have the highest yield. Investors who bought these Dow stocks at the beginning of each year, without consideration of any other factors, have fared well (U.S. News & World Report, 1996). Should CEIC investors who buy discounted funds at the beginning of the year, and rebalance their investments after one-year holding periods expect to profit?

This study evaluates four simple CEIC trading strategies. Using one year holding periods, the plans select funds trading at either maximum discounts or higher than average discounts. The appeal of these investment strategies is their simplicity. They provide a longer holding period and fewer transactions than previous studies. The initial investment is smaller, and short selling is not required. This makes the strategies particularly appealing to small investors, who are active in the CEIC market. These investors lack the time and resources to follow the more complex systems developed in earlier studies. In fact, any investor could easily duplicate these strategies.


Premiums and discounts on CEIC shares are determined by comparing the market price of the shares to the Net Asset Value (NAV) of the fund's holdings on a per share basis. If the fund's market price is less than the NAV, then the fund sells at a discount; if it is greater than the NAV, it trades at a premium. When the discount or premium exceeds a value that can be adequately explained by market forces (Malkiel, 1977; Pratt, 1966), the departure from NAV is deemed excessive and suggests market inefficiency in setting fund prices. Thus, the size of the discount or premium is a key consideration in selecting CEIC shares. Most closed-end funds sell at a discount, and this discount has persisted over time (Pontiff, 1994). This paper focuses on profitable trading strategies, rather than explaining the existence of the discount.

Several researchers have devised trading strategies that attempt to select profitable funds based on the size of the discount or premium. Thompson (1978) reveals that funds trading at a premium are bad investments. He creates portfolios that incorporate all funds trading at a discount. He finds significant performance that is consistent across benchmark portfolios, even after adjusting the returns for tax receipt distributions and reinvestment options. Richards, Fraser, and Groth (1980) focus on two strategies: buy and sell trading points and filter rules. Their strategies involve buying CEIC shares trading at a discount and shorting CEIC shares trading at a premium. Using weekly rebalancing, all of their strategies outperform the S&P 500. They find that the extreme buy and sell points and largest filters produce the highest returns. Anderson (1986) extends their study to investigate three different time periods. He demonstrates that only the buy and sell points provide excess returns for all three periods. …

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