Arbitrage in Closed-end Funds: New Evidence
by Sean Masaki Flynn (Jan. 2004)
NOTE: This paper contains a subtle but crucial data analysis error. As a result, it conclusions are not only incorrect but, in fact, diametrically opposed to what is actually true. The correct analysis has been incorporated into Vassar College Department of Economics Working Paper Number 69, which is entitled, “Noise-trader Risk: Does it Deter Arbitrage, and Is it Priced?” As a matter of intellectual honesty, however, this paper will remain posted here as a historical document. But, again, its conclusions are in error! The error is described in detail in footnote number 8 of “Noise-trader Risk: Does it Deter Arbitrage, and Is it Priced?”
Abstract: Arbitrage pressures that could equalize closed-end fund share prices with fund portfolio values appear to be largely absent in an extensive data set. Observed fund behavior violates the static arbitrage bounds of Gemmill and Thomas (2002) and is inconsistent with the dynamic arbitrage bounds of Pontiff (1996). Furthermore, Fama and French (1992) regressions run on arbitrage portfolios designed to profit from closed-end fund mispricings generate excess returns that are either significantly negative or insignificantly different from zero, suggesting that arbitrageurs lack a profit incentive. If arbitrage is absent, observed fund pricing behavior likely reflects changing investor sentiment about fund prospects.