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A Neoclassical Look atBehavioral Finance: 

A Neoclassical Look at Behavioral Finance The Closed End Fund Puzzle by Steve Ross MIT IMA Public Lecture Series Institute for Mathematics and its Applications University of Minnesota March, 2004 Copyright © 2002 Steve Ross

Neoclassical Finance: 

Neoclassical Finance Efficient Markets Information is captured in prices No Arbitrage Risk Neutral Pricing Theory of Derivatives Asset Pricing Models

Neoclassical Finance: 

Neoclassical Finance Key Assumptions: There are enough well financed smart investors to close arbitrage opportunities Such arbitrageurs are rewarded which means that there must always be profit opportunities in the market A theory of ‘sharks’ NOT a theory of rational man

The Behavioral Challenge: 

The Behavioral Challenge Two Pillars: People aren’t rational Kuhn argues that science progresses through cataclysmic paradigm shifts: Data mounts that doesn’t fit the established orthodox views New theories develop

Samuelson:: 

Samuelson: 'Science progresses funeral by funeral'

Behavioral Finance: 

Behavioral Finance Taking Kuhn to heart, currently its defined more by what it doesn’t like about neoclassical finance than by what it offers as alternatives: Anomalies in the data force us to reconsider and abandon neoclassical finance Prices are determined by ‘everyman’ and cannot be arbitraged

Examples of Anomalies: 

Examples of Anomalies MCI: A company whose ticker symbol is ‘MCI’ and whose price goes up and down with the ‘real’ MCI even though they are completely unrelated (Rashes, M.S. (2001), ‘Massively Confused Investors Making Conspicuously Ignorant Choices (MCI-MCIC)’. Journal of Finance, October) Momentum or P/E strategies in the stock market Internet stocks and the whole US market are overvalued

Anomaly Characteristics: 

Anomaly Characteristics They are ‘small’ Small $ (e.g., MCI Jr. vs. MCI) Not scalable, e.g., illiquid Statistically suspect Volatility Tests Fleeting E.g., the small stock premium, see Schwert [2000] Heisenberg Principle of Finance Not profit opportunities Bid/Ask spreads Information costs, e.g., complex mortgage instruments

Prices  Fundamentals: 

Prices  Fundamentals Internet Stocks and the whole market Royal Dutch Shell and Shell Trading But, ‘fundamentals’ are inherently ambiguous and depend on some pricing theory

Closed End Funds: 

Closed End Funds Fundamentals are unambiguous; net asset value (NAV)

Example: 

Example

Discount Life Cycle: 

Discount Life Cycle

Closed End Funds: 

Closed End Funds Data Trade at discounts from NAV Discounts are correlated across funds Discounts narrow as market rises Discounts disappear when funds are opened up Begin life at an IPO premium! Country funds rise and fall in value depending not just on domestic returns but also with the US market

Closed End Funds: 

Closed End Funds Discounts are an affront to the Law of One Price An enduring puzzle Closed end funds are the poster children of Behavioral Finance Have generated a huge behavioral literature Lee, Schleifer, and Thaler [1991] De Long, Schleifer, Summers, and Waldmann [1990]

Neoclassical Explanation(Malkiel [1977]): 

Neoclassical Explanation (Malkiel [1977]) Agency costs Discounted value of management fees Too small Discount is insensitive to interest rates Constant percentage of NAV implies discount couldn’t move with market Tax effects Embedded capital gains Liquidity of fund holdings

Behavioral Explanation: 

Behavioral Explanation Discounts and premiums are a function of investor sentiment Investor sentiment is correlated across investors implying discounts are correlated across funds Arbitrage is costly and problematic Managers fight opening up their funds and fight takeovers Correlated investor sentiment makes arbitrage risky; discounts could widen But, even if arbitrage isn’t possible, then why don’t large holders buy discounted funds instead of holding their underlying assets?

Neoclassical Analysis Reprised: 

Neoclassical Analysis Reprised Earlier work dismissed management fees But, early analysis used an inappropriate technology to value fees; discounted projected cash flows Fees are a derivative on the fund NAV An interesting case of scientific sociology; everyone just quoted the previous papers as ‘proof’ that fees didn’t matter

Valuing Fees:Proposition 1: 

Valuing Fees: Proposition 1 Fix fees and expenses as a percentage of NAV,  Dividend payout is a percentage of NAV,  Fee based discount is: Discount = /( + )

Proposition 2:Fixed Termination Date: 

Proposition 2: Fixed Termination Date Discount = /( + )(1 – e- ( + )T)

Proposition 3: Dividend Payouts: 

Proposition 3: Dividend Payouts

Proof of Proposition 3:: 

Proof of Proposition 3:

Capital Gains Distribution Rules: 

Capital Gains Distribution Rules A variety of different valuations are derived dependent on the payout policy: A positive feedback from discounts to payouts – an equilibrium in expectations Payouts negatively dependent on performance relative to a benchmark Payouts designed to maintain a constant NAV

More Extensions: IPO Premiums: 

More Extensions: IPO Premiums A simple information story where the buyers get strong initial signals would accommodate this finding IPO’s are designed to prevent buyers from inferring information from prices The first buyers may simply be ‘irrational’ Nothing in neoclassical finance requires people to be rational and there is no inconsistency in my agreeing that Most of the time most of the people can be wrong The efficient market protects the sheep from the wolves but nothing protects the sheep from themselves

Data Set: 

Data Set   Sources: Time period: January, 1980 – December, 2000   Data: Frequency: Source:   NAV monthly Wall Street Journal and checked against Bloomberg Prices monthly CRSP   Dividend and yearly CRSP, Bloomberg, SEC filings Capital Gains distributions   Fees and expenses yearly SEC company filings   Market index returns monthly CRSP   Risk free rate monthly CRSP (one-month T-bill)   Only equity funds with at least five years of observations in the twenty year period were included. A few funds were excluded due to a lack of data on management fees or distributions. The final sample had 21 funds.   To obtain the annual change in NAV, the following year’s capital gains distribution was added back in. Timing of the distributions varied from fund to fund and the adjustment was made to capture the actual gains in the year. The detailed adjustment is reported in the appendix.  

Theory Meets the Data: 

Theory Meets the Data The sample average discount: 7.7% The simple fee based theoretical discount: 7.7%

Table 1: 

Table 1

Discounts, NAV’s, and Market Returns: 

Discounts, NAV’s, and Market Returns Discounts are positively correlated with NAV’s Discounts are negatively correlated with market returns But, they are positively correlated with the difference between NAV and market returns Given the difference, neither NAV nor market returns has explanatory power

Table 2: 

Table 2

Distribution Dynamics: 

Distribution Dynamics Capital Gains Distributions are significantly positively related to discounts and past distributions

Table 3: 

Table 3

Some Further Anomalies: 

Some Further Anomalies Discounts are correlated: They move with NAV and NAV’s rise when the market rises Country funds’ discounts move with the market in which they are traded: Capital gains policies depend on the investors’ home market, hence, country fund discounts move with the investors’ home market

Neoclassical vs. Behavioral: 

Neoclassical vs. Behavioral Parsimony vs. Ad hocery No arbitrage and efficiency produce the answer Psychology produces too many answers and no theory Are people optimists or pessimists – they are both Neoclassical theory predicts magnitude as well as signs of effects Aesthetics; I like theories with some distance between assumptions and conclusions You want correlations then just make individual behavior correlated

Gratuitous Concluding Remarks: 

Gratuitous Concluding Remarks Psychology is a hodgepodge of interesting empirical observations devoid of theory Psychology has value for marketing and flows of funds but not for valuation Arbitrage may be limited, but In the behavioral models it is so by force majeur Behavioral models limit both markets and institutional structures to produce results Bubbles aren’t bubbles until they burst Two assets with identical cash flows may sell for different prices, but not for long