Closed-End Investment Fund Discounts. Closed-end funds usually trade at substantial discounts relative to their net asset values. There are several types of explanations:

• Agency costs. The existence of management fees (from 0.5% to 2%) implies that funds will sell at a discount. However, open-end funds also charge fees. Boudreaux (1973) suggested that since fund managers buy and sell securities, discounts might reflect their differential ability to perform this task. However, this explanation does not explain why funds trade, on average, at discounts.

• Taxes. When a fund realizes a capital gain it must report this, and the tax liability is borne by the existing shareholders at the time the gain is realized. So if you buy a fund today and it realizes a large capital gain tomorrow, you must pay a tax even if you have not made any money. This implies that a fund with large unrealized capital appreciation is worth less than net asset value to both existing and potential shareholders, and should thus sell at a discount. The explanation, like the others, has some apparent merit but fails to explain all the facts.

• Liquidity. One way in which the portfolio might be misvalued is if the fund held large quantities of stocks which cannot be freely sold in the open market. Such stocks, some have argued, are valued too highly in the calculation of net asset value. However, most closed-end funds hold little or no restricted stock and yet still sell at discounts.

When closed-end funds are terminated, either through merger, liquidation, or conversion to an open-end fund, prices converge to reported net asset value.

In summary, a number of reasons have been put forth to explain closed-end fund discounts in the context of the efficient market hypothesis and rational agents. Several of these factors do have some merits, but taken together, these factors explain only a small portion of the total variation in discounts.