Payout policies and closed-end fund discounts: Signaling, agency costs, and the role of institutional investors (original) (raw)

2011, Journal of Financial Intermediation

In recent years, some CEFs, often under pressure from outside shareholders, have adopted managed distribution policies or plans (MDPs) to reduce fund discounts. Under MDPs, fund management prescribes a minimum payout target in any given fiscal year, regardless of the realized performance of the underlying asset portfolio. 2 Typically, the policy involves quarterly or monthly distribution to common shareholders, either as a fixed percentage of average NAV or as a fixed dollar amount. For MDP funds in our sample, the payout target ranges from a low of 5% to a high of 20%, with a median around 10% in most years. The payout target is met through investment income and realized shortterm/long-term capital gains, with any shortfall being covered by a distribution of fund capital. In our analysis, consistent with industry norms 3 and with previous research (Johnson et al., 2006), we use the 10% payout target as the cutoff for moderate versus aggressive payout policies. The MDPs appear to have had remarkable success in reducing, if not eliminating, fund discounts (see Wang, 2004 and Johnson et al., 2006). In our sample, for instance, MDP funds exhibit an average (monthly) median discount of only 0.86% over the 1990-2006 period, with the more aggressive-MDP funds (payout targets P10%) trading at an average premium of 2.32%. In striking contrast, funds without the MDP (hereafter, non-MDP funds), have an average (monthly) median discount of 10.19% over the same period. In this paper we seek to understand the popularity of MDPs and their apparent success in reducing fund discounts. We consider two primary hypotheses-signaling and agency costsand explore their empirical implications. The signaling hypothesis advanced in the literature (Johnson et al., 2006) is that a MDP can serve as a costly signal of the fund's future NAV performance. The claim, based on somewhat informal arguments, is that MDP funds that perform poorly may be obliged to return capital to investors. Hence, only funds sufficiently confident of future performance would commit to such a target policy. A key implication of the signaling hypothesis is that MDP adoption signals strong future NAV performance and will, therefore, tend to boost share prices and reduce discounts. We would also expect, as is suggested by most formal signaling models, that a stronger signal in the form of a more aggressive-MDP will presage an even stronger performance and induce a larger price boost. A caveat in our approach to testing the signaling hypothesis should be pointed out: we take the arguments made in the literature at their face value and assume that a signaling equilibrium in MDPs can exist. However, as we briefly discuss, the theoretical basis for such a signaling equilibrium is weak. The reason is that better performing funds face greater costs from adopting MDPs and may have little incentive to signal in this fashion. Hence, any evidence supportive of MDP signaling needs to be interpreted with some caution. An alternative approach to understanding MDPs is based on the agency cost hypothesis. In developing the hypothesis, we recognize the somewhat different ways in which agency problems may be manifested and impact fund discounts and performance. For instance, agency problems between managers and investors could lead some funds to become large relative to managerial investment abilities/ opportunities. In these cases, inducing funds to shrink their size (or moderate their growth) benefits investors, 4 with the adoption of an aggressive payout policy leading to an improvement in both fund performance and discount. However, MDPs may not necessarily improve fund performance when agency problems are present. The reason is that fund discounts may, for instance, reflect the rent extracted by fund managers in excess of value-added (Berk and Stanton, 2007; Cherkes et al., 2009a). The adoption 1 As with open-end funds, CEFs typically invest in publicly traded securities and manage their holdings for income and capital appreciation. Unlike open-end funds, which offer and sell their shares continuously, CEFs raise capital by selling publicly traded shares in an IPO and subsequent equity offerings. Open-end funds provide liquidity to their shareholders by redeeming shares at a price based on NAV. Shareholders of CEFs, on the other hand, can sell their shares on the secondary market at prices that may vary significantly from NAV. Lee et al. (1991) provide a detailed description of the characteristics of CEF discounts. 2 While funds can always terminate the payout policy, they hesitate to do so given the likely negative shareholder reaction that would ensue (see, for instance, footnote 5). It is reasonable to assume, therefore, that investors would perceive MDPs as a commitment they expect fund management to honor. 3 The generally accepted view in the industry is that to be effective (in terms of reducing discount), MDPs should involve the distribution of at least 10% of average net asset value on an annual basis. See The Investor's Guide to Closed-End Funds, May 2007 (pg. 27), published by Thomas J. Herzfeld Advisors Inc. The issue also describes the history of the MDP and provides a current list of MDP funds. 4 The notion that performance may decline with fund size has been made by several papers in the context of open-end funds (e.g., Berk and Green, 2004).